Do you know what gets me about the recent stock market blowup?
Somebody out there made a bundle off it.
I know, it's hard to believe. Most folks' retirement account balances are way down. Every single stock mutual fund (all 11,579 of them) is down this year, and highfliers from Akamai (Nasdaq: AKAM ) to Apple (Nasdaq: AAPL ) -- and that's just the beginning of the alphabet -- are way off their recent highs.
But somewhere out there are investors who made money this year. Lots of money, in some cases.
Many are professionals, of course -- hedge fund managers and others with access to sophisticated tools and strategies -- but others are just ordinary individual investors like you and me. Like you and me ... except that they've learned to use tools and strategies we haven't.
Like going short.
The long and short of it
Most mutual funds aren't allowed to short stocks -- to borrow and sell them, in other words, betting that they'll be able to buy the stock back at a lower price and make money on the difference. Many individual investors avoid the practice as well. The risks are high, the upside is limited, and shorting can't be done at all without a margin account, which excludes most retirement accounts.
But sometimes shorting a stock -- or a sector, or an index -- is a prudent investment. Markets go down as well as up, as we've seen recently. Sectors fall out of favor. Companies sometimes appear headed for disaster long before the wider market catches on, as was the case with Lehman Brothers for a while. Bubbles appear, become evident to some, and then pop.
Shorting banks, oil, or other commodities earlier this year would have been an excellent move, and the weaknesses in all three of those areas were visible to some folks at the time. But how many profited? A lot fewer, because shorting is dicey, and, as I mentioned previously, it's a strategy unavailable to most who do their investing via IRA accounts.
But that's changing. New tools allow investors to take short positions without the need for a margin account. These offer great opportunities for the informed -- along with some new risks.
Enter the short ETF
Most investors are familiar with ETFs. Exchange-traded funds track a wide variety of indexes and are traded throughout the day, like stocks. In recent years, companies like ProShares have created families of short ETFs -- investments that go up when the indices they track go down. (And -- this is important -- vice versa.)
The selection has grown rapidly. ProShares alone offers an extensive selection covering all the major U.S. and international indices, sectors from financials to industrials to health care, commodities including gold and crude oil, major currencies, and more.
Be careful of that lever
Many of these are leveraged, or what ProShares calls "UltraShort," so for every 1% move down in the underlying index, the fund is supposed to go up about 2%. They don't track precisely in practice, but close enough to work out well if you're right, and to cost you a bundle if you're wrong (although unlike a true short position you can't lose more than your original investment). Still, tread very carefully with these products.
The lack of precision has been an issue for some short ETFs. While a fund like UltraShort Oil & Gas (NYSE: DUG ) is designed to inversely track an index that includes obvious sector heavyweights like Chevron (NYSE: CVX ) , Schlumberger (NYSE: SLB ) , and ExxonMobil (NYSE: XOM ) , the fund's actual holdings are complex derivatives, not short positions in those stocks. The "black box" aspect can be a turnoff for some.
Nonetheless, these ETFs remain useful tools -- not the one fund to carry you to retirement, but a way to take a well-thought-out position on the market, in a sector, or on a currency or commodity. But for once, I'll advise you to think in the short term on these investments. Long is the way to bet long term, as this bear market won't last forever.
Putting it all to work
I've used short ETFs in a small way in the past few months. Most significantly, in the midst of the market crash in early October, I threw a portion of my portfolio's cash position into UltraShort S&P 500 ProShares (NYSE: SDS ) , which acted as a sort of brake on my portfolio as the declines continued. In that case, the double leverage was exactly what I wanted -- to have a big effect with a relatively small investment.
More recently, I've explored using both long and short ETFs to take longish-term positions on currency movements and sector strengths. The Fool's new $1 million real-money portfolio, Motley Fool Pro, is employing similar strategies using ETFs and short positions together with a core stock portfolio, and I've learned a lot by following its investments.
If you're interested in learning more about Motley Fool Pro and long and short strategies using ETFs, the service will be reopening soon, but for 10 days only. To learn more, and to get your private invitation to join, simply enter your email address in the box below.