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Inverse Exchange Traded Funds (ETFs)

Written By Brian Hicks

Posted April 24, 2008

You don’t exactly need to be Jesse L. Livermore to make big profits in a down market these days, although it certainly wouldn’t hurt.

Livermore, of course, made massive fortunes betting against the markets, along with what became his ultimate claim to fame. Livermore went short the market in 1929 earning himself $100 million in short-selling profits.

That big haul though was only a part of his legend as he traded his way to riches in the days when they still literally read the tapes. Long or short it didn’t matter to Jesse, he took what the markets gave him.

Of course, trading has come along way since those early days when the prices on those tapes were often hours off the mark.

Fortunately, going short has gotten quite a bit easier too these days thanks to exchange traded funds.

In fact, by going long any number of inverse exchange traded funds, investors of every stripe can be short the markets without the mystery.

Taking the Mystery Out of Short Selling

Now, I use the word mystery there for a reason. That’s because if there is one facet of the markets that is the least understood, it has to be shorting or short selling. Many investors simply don’t even understand how it works.

In fact, I often say that I could spend days roaming around the city of Baltimore before I could actually find someone who could tell me how short selling works. That to me is something of a problem, especially if you consider yourself a serious investor.

It would be like calling yourself a serious football fan and without knowing anything about the forward pass. Short selling is just as vital.

So here’s the way a short sale works. It involves a bet that a particular sector or stock is going to drop.

What you do then is borrow shares of that stock from a broker. Now forget for a moment what those shares cost when you borrowed them. It’s not important.

What is important is this: You borrowed shares from someone and you need to give them those shares back.

Let me repeat that. You borrowed shares from someone and you need to give them those shares back. That’s the deal. The price is important only in the end.

Of course, what you do then with those borrowed shares is what makes it a short sale. That’s because you don’t keep them in your account, you sell them.

And when the price of those shares goes down you buy them back and "cover your short", returning the shares to the broker you borrowed them from. You profit by the difference between what you sold them for and what it cost you to buy them back.

For instance, say you wanted to short Centex Homes (CTX) a few years ago because you knew that the housing bubble was about to burst. You could have borrowed 1000 shares of CTX from your broker and sold them short for $60 a share. That would have put $60,000 into your account.

Now, as your thesis played out you could have bought those same 1000 shares of CTX back as housing totally tanked for as low as $18 a share. That would have cost you $18,000.

So your broker would get back the 1000 shares of CTX that you borrowed and you would get to keep the difference—a cool $42,000 for your troubles.

Neat deal huh? But it’s not for everybody.

Short selling is risky because if the trade goes against you, your losses are unlimited. After all, CTX could have gone to $200 a share, costing you $200,000 to buy back—-a $140,000 loss. Ouch.

Moreover, short sellers must establish a margin account on these transactions and pay interest —as high as 8%—on these sales, along with the real possibility of a margin call.

So it is a bit complicated. However, for most investors just simply understanding what a short sale is and how it works is the equivalent of an epiphany.

Inverse Exchange Traded Funds (ETFs) Explained

But as said earlier, short or inverse exchange traded funds make betting against the markets considerably less complicated because all you have to do is go long—a transaction that everyone understands. And it doesn’t require a margin account.

The best part though is this: Your potential losses are limited. That’s because since you are long on the fund the worst it can possibly do is go to zero. And while that certainly isn’t good, it is much better the limitless losses possible with a true short.

Inverse ETF’s, however, are broad market bets that a particular sector or index is headed south. They seek investment results that correspond to the inverse (opposite) of the benchmark, or index, with which they are associated.

For example, the Short QQQ ProShares (AMEX:PSQ) is a fund that seeks results that correspond to the inverse of the performance of the NASDAQ-100 Index. As the index drops, the PSQ rises. Simple enough.

But what also makes these funds unique is how they are constructed. They don’t actually short stocks but trade in derivatives, such as futures and options to bet against the index.

That construction allows for leverage and the creation of what is known as an Ultrashort ETF.

Ultrashort ETFs can juice up those downside bets by providing as much as 2.5 times the inverse of the index it tracks. So when an index drops 1 point the gain for the ultrashort is 2.5.

The UltraShort QQQ ProShares (ETF) (AMEX:QID) for instance, provides 2 times the inverse of the Nasdaq-100. It’s like the PSQ on steroids.

But be warned, the magic of leverage is as painful on the way down as it is good on the way up. Also, be aware that over most long periods of time, the U.S. stock market has moved in one direction: up. So overall, the market goes up more than it goes down.

Keep that in mind as you trade.

So what ever happened to Jesse L. Livermore?

He made and lost more fortunes than most traders can even contemplate. But he didn’t die a poor man by any stretch of the imagination.

He did, however, kill himself believing that he was "a failure", proving once again that money can’t buy happiness.

Of course, it certainly doesn’t hurt either.

Here, by the way is a list of some of the inverse exchange traded funds available today. They are a great way to hedge your portfolio in a market downturn.

Your bargain-hunting analyst,

steve sig

Steve Christ

Chief Investment Strategist

The Wealth Advisory

PS. Do you want to learn more about the markets and how to make money—even in an economic dowturn? Steve has the answers. Join The Wealth Advisory today. Along with winning stock picks, it is a serious education for the serious investor. Click here for more information.