Inverse ETFs allow investors to capitalize on a falling market without having to short anything. They can be handy if you are pessimistic about a particular market or sector, but what if your predictions are wrong and the opposite happens? Can your inverse ETF go to zero or even negative?
Inverse ETFs never go to zero or negative since their values reset daily. For an inverse ETF to hit zero, the value of its assets have to go up 100% in a single day, which is unlikely. However, some leveraged and volatile inverse ETFs do converge to zero.
This article will cover more information about inverse ETFs and how they work. You will learn how to minimize the risk of losses when dealing with inverse funds and whether they are a safer option than traditional short-selling.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
How Do Inverse ETFs Work?
Despite an upwards trend in the long-term, the stock market is highly unpredictable on a day-to-day basis and tends to go up and down constantly.
Inverse ETFs allow you to take advantage of these short-term falls in the market. For example, if the Nasdaq 100 index trades -2% on the day, the PSQ (Nasdaq 100 Inverse ETF) will experience a 2% gain.
Inverse ETFs are built on various derivatives (options, futures, swaps) and are mathematically constructed to react the opposite of how the index is doing on a particular day.
When it comes to inverse ETFs, it is essential to understand that they reset daily. So, if an index is down 15% for the entire year, the inverse ETF won’t necessarily be up 15%, as it can only replicate the index one day at a time.
The fact that they reset daily is the main reason why inverse ETFs are never used for long-term investing, as there are plenty of other more suitable investment vehicles for that.
Due to the effort required to manage these funds, they are also a lot more expensive than a regular ETF.
How To Minimize Losses With Inverse ETFs?
While you can never fully guarantee to stop losses in the stock market, there are certain things you can do to minimize them.
Here are a few things you can do to minimize your losses when dealing with inverse ETFs:
Only Use Them in a Bear-Market
A bear market is considered a period of prolonged decline in the stock market and overall pessimism about its future. The opposite of a bear market is a bull-run, and the stock market operates in a cycle of bull and bear markets.
It would be wise only to utilize inverse ETFs for risk management purposes while the stock market is in decline. Sure, you a bull-run doesn’t mean that every listed index will be trending up, and you can still make profits betting against some indexes, but your investment will be a lot safer if the overall market is in a state of uncertainty.
Make Sure They Aren’t Leveraged
With thousands of ETFs out there, it can be easy to confuse what each of them does exactly. It is important to know that inverse ETFs can be leveraged. A leveraged inverse ETF amplifies the performance of the underlying index. For example, if a regular fund follows the index at a 1:1 ratio, the leveraged fund aims for a 2:1 or 3:1 ratio.
While this type of fund can double or triple your gain when the index drops, it will also lose you twice or thrice as much if the index trades in the opposite direction.
It would be best if you stuck to regular inverse ETFs that trade at a 1:1 ratio with their corresponding index to minimize your chance of losses.
Don’t Hold Them for Too Long
Novice investors may overlook that inverse ETFs only correspond to their underlying index on a day-to-day basis. Thus, it makes no sense to hold an inverse fund over a more extended period.
The best strategy to use when dealing with inverse ETFs is to follow market trends and stick to relatively short-term investments.
If you want to hold an inverse fund for longer, you should make daily adjustments to your positions to accumulate for the compounding risk.
When Can Inverse ETFs Reach Zero?
It is improbable for regular inverse funds to reach zero. However, highly leveraged inverse ETFs, especially those that amplify the index three times, tend to converge to zero over a more extended period.
Even 2x inverse funds could potentially reach zero eventually if the price of the underlying index is highly volatile. All of this happens due to compounding returns.
This brings us back to the previous points where I talked about how you can minimize your losses. The combination of leverage and long-term holding are sure ways to lose your entire initial investment. To avoid this, stick to short-term daily trading when it comes to inverse ETFs.
Are Inverse ETFs Safer Than Short-Selling?
If you are pessimistic about the market, an index, or a sector, inverse ETFs are the safest option you have to profit on your speculation. Before inverse ETFs became popular, investors had to short stocks, which is a more expensive and riskier ordeal.
Short-selling in the stock market refers to the process of borrowing shares and selling them at their current price. Then, you wait for the price to drop and return the borrowed shares while making a profit on the difference.
What makes this process very risky is that if the share price soars and keeps soaring, the amount of money you could potentially lose is unlimited.
Inverse ETFs eliminate the danger of unlimited losses. With that said, the potential gains are also limited to the daily performance of a particular index unless the fund is leveraged.
How To Use Inverse ETFs?
Many seasoned and institutional investors utilize inverse ETFs as part of their trading strategy. These funds can be an excellent investment vehicle when stocks are falling, and everyone else is fleeing the market.
Sometimes, the market crashes way quicker than it rises, and if you can benefit from some of those crashes, you could boost your earnings with the stock market.
How do you do that?
- Weekly charts can help you notice when the market is getting bearish. When you see a downward pattern, is when you should start thinking about utilizing inverse ETFs.
- Risk management is another reason why you might want to invest in inverse ETFs. If you have a significant portion of your portfolio invested in a particular index, it would be wise to put some cash into its inverse ETF to manage some of that risk.
- Don’t buy and hold. If you remember that inverse ETFs are a short-term investment vehicle, you can learn to use them correctly to capitalize on falling markets.
You can also check out this video by Charting Wealth to learn how to invest in inverse ETFs:
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Conclusion
Inverse ETFs allow you to profit when the market is falling. When they are highly leveraged and follow a volatile index, inverse ETFs could converge to zero.
To avoid huge losses when using inverse funds, you should only use them for short-term trading, ensure they aren’t leveraged, and only use them during a bear market.
Inverse ETFs are a great way to “bet” against the market and are generally safer than traditional shorting. You can utilize weekly charts to get an idea of how the market is doing and whether inverse positions would be wise at that time.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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