Leverage To The Downside? If QE3 Is Not Announced Next Week Look Out Below!

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Includes: GLD, IWM, SDS, SLV, SPY, TZA
by: Christopher F. Davis

Yesterday the European Central Bank announced an unlimited short-term bond-buying program with some conditions, helping to allay fears that it would not do all it can to save the euro. Although the announcement was somewhat expected, it also held interest rates at current levels, which could be considered a disappointment. The U.S. markets didn't mind and surged on the news even though volume was relatively light for such a rally. Today we were met with yet another pitiful jobs number and downward revisions of prior months. Some are taking this as a sign the Federal Reserve must move on QE3. Maybe it will, maybe it won't. In my opinion if it moves on QE3 it will have minimal impact as I suspect it has been baked into the markets. If it does not announce QE3 this month I think we will finally see this rally exhaust and a sell-off ensue. Thus it may be time to get cautiously bearish. For those who are growing more bearish, investors can consider selling stock, selling covered calls on their positions, shorting stocks, buying puts or by investing in a bear fund. While each of these approaches has its respective benefits and risks, in this article I want to highlight two leveraged ETFs that could provide great short-term returns in the event of a market sell-off on disappointing news.

ProShares UltraShort S&P500 (SDS): This leveraged fund seeks "daily investment results that correspond to twice the inverse of the daily performance of the S&P 500. Recall the S&P 500 is "a float-adjusted, market capitalization-weighted index of 500 United States operating companies and real estate investment trusts selected through a process that factors criteria, such as liquidity, price, market capitalization and financial viability." SDS invests in common stock issued by public companies. SDS also invests in derivatives, which are financial instruments whose value is derived from the value of an underlying asset, interest rate or index.

SDS currently trades at its one-year lows at $13.77 a share. SDS has average daily volume of 18.5 million shares exchanging hands. In the last month, SDS is down 5.5% while the SPDR S&P 500 ETF (NYSEARCA:SPY) is up 2.7%. SDS is at the bottom of its 52-week range of $13.75-$28.16.

Direxion Daily Small Cap Bear 3X Shares (TZA): This is my favorite way to invest in a bear market short term. TZA seeks "daily investment results of 300% of the inverse of the price performance of the Russell 2000 Index (also known as the small cap index). The Russell 2000 measures the performance of the small-cap segment of the United States equity universe and consists of the smallest 2,000 companies in the Russell 3000 Index, representing approximately 10% of the total market capitalization of the Russell 3000 Index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership." TZA actually does not invest in equity securities or stocks. What TZA does is creates short positions by investing at least 80% of its net assets in financial instruments to provide leveraged and unleveraged exposure to the Small Cap Index and the remainder in money market instruments.

TZA currently trades at a one-year low at levels of $14.70 a share on average daily volume of 20 million shares. In the last month TZA is down 15.5% compared with the ETF that tracks the Russell 2000 index (NYSEARCA:IWM), which is up 5.4%. TZA is at the bottom of its 52-week range of $14.66-$63.87.

Bottom line: It's a lot easier to make the bear case than it is to make the bull case right now in my opinion. There are lots of ways to prepare for a potential short-term bear market including selling covered calls, buying puts, shorting stocks and stock indices, or just plain old selling equities to raise cash. While I believe the best way to position in the event of QE3 is through gold and silver, either physically, through the SPDR ETF Gold Trust (NYSEARCA:GLD) and iShares Silver Trust (NYSEARCA:SLV), or one of the miners, I believe it is wise to consider a "no QE3" strategy. I think a short-term strategy to consider if you don't believe QE3 is coming is picking up a bearish ETF fund. Both SDS and TZA are my favorites to consider as these funds perform very well in short-term bear markets.

Disclosure: I am long SLV, TZA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.