Inverse (Reverse) ETFs

Written By

Dan Buckley

Updated

Sep 27, 2024

Inverse ETFs, also known as reverse ETFs, are exchange-traded funds designed to profit from a decline in the value of an underlying benchmark.

Unlike traditional ETFs that move in the same direction as their target index, inverse ETFs move in the opposite direction.

For every 1% decrease in the underlying index, an inverse ETF typically tries to increase by 1% (unless levered).

Key Takeaways – Inverse (Reverse) ETFs

Daily Reset Mechanism

Inverse ETFs rebalance daily, potentially leading to tracking errors over time due to compounding effects.

This makes them better suited for short-term trading rather than long-term holding.

Avoids Short Selling

Traders can profit from market declines without needing a margin account or dealing with the complexities of short selling.

Inverse ETFs are more accessible for some.

Hedging Tool

Inverse ETFs can serve as effective short-term hedges for long positions.

The Mechanics Behind Inverse ETFs

These financial instruments use various derivatives such as futures contracts, swaps, and options to achieve their inverse performance.

The fund managers use complex strategies to maintain the daily inverse correlation.

It’s important to understand that most inverse ETFs reset daily, which can lead to unexpected results over longer periods due to compounding effects, which we cover more here and is also true with leveraged ETFs.

Types of Inverse ETFs

Single Inverse ETFs

Single inverse ETFs try to deliver the exact opposite return of the underlying index on a daily basis.

For example, if the S&P 500 drops 2% in a day, a single inverse S&P 500 ETF should theoretically rise by 2%.

Leveraged Inverse ETFs

These ETFs amplify the inverse performance of the underlying benchmark.

Common multiples include -2x and -3x.

A -2x leveraged inverse ETF would aim to increase by 4% if the tracked index falls by 2%.

These products carry higher risks and potential rewards.

They’re built specifically for day traders and not for holding periods beyond one day due to the abovementioned compounding effects.

Popular Inverse ETF Targets

Major Market Indices

Many inverse ETFs track broad market indices like the S&P 500, Nasdaq 100, or Dow Jones Industrial Average.

These offer a way to hedge, short, or bet against overall market sentiment.

Sector-Specific Inverse ETFs

Some inverse ETFs focus on certain sectors (e.g., technology, finance, energy).

These allow traders to capitalize on anticipated downturns in specific industries.

Commodity Inverse ETFs

Traders can also find inverse ETFs for commodities like gold, oil, or agricultural products.

These provide opportunities to profit from falling commodity prices without directly shorting futures contracts.

Currency Inverse ETFs

For forex traders, currency inverse ETFs offer a way to bet against certain currencies or currency pairs without dealing with a separate asset class entirely.

Advantages for Day Traders

Shorting Without Margin Accounts

Inverse ETFs allow traders to profit from market declines without needing a margin account or dealing with the complexities of short selling (e.g., interest costs, borrowing costs).

This accessibility makes them attractive to many retail traders.

Liquidity and Ease of Trading

Most inverse ETFs are highly liquid, with tight bid-ask spreads.

They trade just like stocks, making them easy to buy and sell throughout the trading day.

This liquidity is important for day traders who need to enter and exit positions quickly.

Limited Downside Risk

Unlike short selling, where potential losses are theoretically unlimited, inverse ETF losses are limited to the initial investment.

This cap on potential losses can be reassuring for risk-averse traders.

Diversification Tool

Inverse ETFs can serve as a hedging mechanism, allowing traders to protect their long positions during market downturns without liquidating their portfolios.

Risks & Considerations

Daily Rebalancing and Volatility Decay

The daily reset feature of most inverse ETFs can lead to significant tracking errors over time, especially in volatile markets.

This phenomenon, known as volatility decay, can erode returns even if the underlying index moves in the desired direction over an extended period.

Leverage Amplifies Risks

Leveraged inverse ETFs magnify both gains and losses.

A small move against your position can quickly lead to substantial losses, especially with -2x or -3x products.

Counterparty Risk

Since inverse ETFs rely heavily on derivatives, they expose traders to counterparty risk.

If the institutions providing the swaps or other derivatives face financial difficulties, it could impact the ETF’s performance.

High Expense Ratios

Inverse ETFs typically have higher expense ratios compared to traditional ETFs due to their complex management strategies.

Trading Strategies with Inverse ETFs

Momentum Trading

Day traders often use inverse ETFs to capitalize on short-term downward momentum in markets or sectors.

Pairs Trading

Some traders use inverse ETFs in conjunction with traditional ETFs to create market-neutral strategies.

For example, going long on a sector ETF while simultaneously holding an inverse ETF of a broader market index can isolate sector-specific performance.

Hedging Intraday Positions

Inverse ETFs can serve as short-term hedges for long positions.

If a trader anticipates negative news or market volatility (e.g., upcoming earnings from major companies in an index), they might buy an inverse ETF to offset potential losses in their long positions.

Trend Reversal Plays

When markets or sectors appear overbought and due for a correction, traders might use inverse ETFs to position themselves for a potential reversal.

Best Practices for Trading Inverse ETFs

Understand the Product

Before trading any inverse ETF, thoroughly research its structure, underlying index, and rebalancing mechanism.

Monitor News and Economic Data

Stay informed about market-moving events, economic releases, and sector-specific news.

These factors can dramatically impact the performance of inverse ETFs in the short term.

Use Strict Risk Management

For day traders, use stop-losses that adhere to your predetermined risk tolerance.

The leveraged nature of many inverse ETFs can lead to rapid losses if positions move against you.

Avoid Holding Overnight

Be wary of holding for more than one day due to the daily reset structure and consequent compounding effects.

As such, holding inverse ETFs overnight can lead to unexpected results.

Day traders should typically close positions before the market closes to avoid overnight gaps and compounding effects.

Analyze Liquidity and Spreads

Choose inverse ETFs with high trading volumes and tight bid-ask spreads.

This allows you to enter and exit positions quickly without significant slippage.

Consider Correlation with Other Positions

Be aware of how inverse ETF positions correlate with your other trades.

Unintended correlations can amplify portfolio risk or negate the effectiveness of hedging strategies.

Conclusion

Inverse ETFs offer day traders ways to profit from market declines or hedge existing positions.

Their ease of use, liquidity, and ability to sidestep traditional shorting restrictions make them potentially attractive instruments for short-term trading strategies.

Nonetheless, their complex structures and daily rebalancing require a thorough understanding and careful risk management.