Inverse ETFs bet on asset price declines

Introduction to Inverse Exchange-Traded Funds

It's possible to make money betting on bear markets. Inverse ETFs are one of the ways to do so.

Many investors fear bear markets. Some look to hedge (protect their gains), while others seek to make profits from market declines. So, what can be done before a bear market comes? One of the ways to make a bet on falling prices is to sale shares short. It involves selling shares the investor doesn’t own, hoping to re-buy them later at a lower price. Options are another way. This includes buying puts.

Yet another possibility is to purchase Inverse ETFs. More and more investors are becoming familiar with these investment vehicles. ETFs have become increasingly popular in recent decade as a cheaper alternative to mutual funds. Their ascent started in the early 2000s.

Nowadays, there are multiple ETFs which make bets on market declines. These are the so-called Inverse ETFs, such as Proshares, which are open to the public. An Inverse ETF can, for example, be based on an index (i.e. S&P 500). If the index declines, the price of ETF will rise (and vice versa). Some ETFS are leveraged 2 or 3 times, meaning the index move is multiplied. These are intended for real bears. One example includes Velocity Shares that bet on on oil's decline. While Inverse ETFs offer opportunities, be careful: making a bet on declines is a double-edged sword.

Also note that these funds (whether long or short) may not rise exactly as the underlying indices. The reason is that they are often based on futures contracts. When these contracts are rolled over, there's a gap. One reason could be due to contango. What typically happens with commodities is that they need to be stored, which costs money. As a result, the futures contracts in the future are often cheaper, which is called a backwardation. So when a futures contract is rolled over, it doesn't cost as much. However, at times, due to expectations of higher prices in the future, these contracts may be more expensive. Then contango develops. This means it is more expensive to roll over the futures contracts, thus decreasing potential gains.

When it comes to leveraged ETFs, they need to be balanced daily. This can lead to losses even if investors bet right on the direction.

For example, an underlying index goes down 10%. So let's say a 3x leveraged ETF declines 30% from 100 to 70. Then, the next day, the underlying index rises 10%, so the ETF goes up 30%. But, from 70 base, the new price is 91. which is still 9% below the original value. At the same time, without leverage, the value would be 99 since initial100 would become 90 after 10% decline, and then a 10% rise would bring it up to 99.

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