We were asked by a listener if shorting an index or the entire market via ETFs is a less risky strategy than shorting individual stocks. While there is certainly some truth to the "less risky" claim, that doesn't make it a good idea.

In this episode of Industry Focus: Financials, host Shannon Jones and Fool.com contributor Matt Frankel discuss shorting in general, as well as the benefits and dangers of using inverse and leveraged ETFs to do it.

A full transcript follows the video.

This video was recorded on Aug. 13, 2018.

Shannon Jones: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. It's Monday, August 13th, and on today's Financials show, we're diving into the Motley Fool mailbag to answer listener questions about the fascinating topic of shorting. Specifically, we'll discuss some different shorting strategies, the risk involved, and ultimately, in the event of a market downturn, should these alternative strategies have a place in your long-term portfolio. We'll get into all of that.

First, I'm your host, Shannon Jones, and I'm joined in the studio via Skype with financials guru and newly minted certified financial planner, Matt Frankel. Matt, congrats! You survived the CFP examination and lived to tell the tale!

Matt Frankel: I did, and I never want to do it again.

Jones: To all you listeners out there thinking about doing it, you heard it straight from Matt's lips, [laughs] it's tough. But obviously, not too impossible to achieve. Matt, tell us what was involved with that.

Frankel: To be a CFP, you need a few different things. You have to have an educational background, so I had to do a graduate certificate in financial planning. I did mine through Florida State University. You also need at least three years of full-time experience in the financial industry, which, I work with The Motley Fool, gave me that. Finally, you need to pass an exam. After that, you take an oath type thing, they call it the ethics requirement. Once you've met all four of those requirements, you can call yourself a CFP, after you pay a registration fee. It's a process. I've been working on it for about two years now.

Jones: Wonderful. That means there's literally no one better qualified to tackle today's show than you, Matt. Let's get right into it.

We recently had an Industry Focus episode, it was the July 20th Tech episode, that was dedicated to the topic of shorting individual stocks. This actually generated a follow-up email that I thought would be a really great topic to tackle. I'll read through it and abbreviate it just for the sake of time.

Our listener says, "On a recent Industry Focus episode, there was a question about shorting. I'm in total agreement that shorting is super, super risky because of the unlimited downside. But what about ETFs that short the market or an index? I think we're all in agreement that at some point in time, there will be a bear market. In any case, when that does happen, I'd like to see some green in my portfolio." I will say, I would like that to happen, too. The listener goes on to say he googled a few short ETFs and listed some of those ETFs as well.

He continues, "I know there are leveraged ETFs 2-3X the inverse of the market. I was wondering if these non-leveraged ETFs are a safer way to short the market. I'm under the impression that if I'm wrong, I would just lose what I invested. I know enough to know I don't know enough about this, so I figured I'd ask my fellow Fools to see if there's something that I've missed or if I'm just flat misinformed."

Matt, newly minted CFP, tell us all about the basics of shorting just to set the groundwork.

Frankel: The short way I can explain short selling is, basically, you're borrowing shares of a stock from somebody else and selling them. You're selling stock that you don't own. Your hope is that the price of the stock will go down so that you can buy them back and give those shares back to whoever you borrowed from at a cheaper price than you sold it for, profiting from the difference. For example, say I wanted to short Apple (NASDAQ: AAPL). Apple is at its record high right now, I think it's gone too high, I could ask my broker to borrow 100 shares of Apple, sell it on the open market. Then, if I'm correct and Apple comes down a little bit, I can buy it back at that new lower price, give my broker back the 100 shares, and I get to profit from the difference.

The problem with that is, it creates unlimited risk of loss. To give you a quick example, I was looking at something I wrote on a blog a long, long time ago. Back in 2007, I thought Amazon (NASDAQ: AMZN) was an expensive stock. It was trading at $39 a share. If I had initiated a short position in that for, say, 100 shares, that means I'm borrowing almost $4,000 worth of stock. If I had held on to that short position until today, I would be very wrong. Amazon trades for over $1,900 a share as I'm speaking. I would be sitting on a loss of about $187,000, on a roughly $4,000 short position. That's an extreme example, and I probably would have gotten out of the position as soon as it started really going in the opposite direction.

But that's just one example of how it can lead to an unlimited amount of loss if you're not careful. The listener who wrote in is definitely correct. It's a risky strategy in that respect. If you're buying the stock, the most you can lose is your investment if the stock goes to zero. But if you're shorting, there's no limit to how high a stock can go, so it makes your risk of loss infinite.

Jones: That's really the scary part, when it comes to shorting. Because of that infinite risk that's involved, there's really no ceiling on how high a stock could rise if you happen to be a short seller. The other key thing is, your thesis could actually be pretty spot-on, but you have to remember that the markets are irrational more often than not. Let's say you're shorting a stock where you believe the company is behind some sort of accounting fraud. The market may not recognize that. As such, the stock price continues to rise. And even though you may be 100% right at the end of the day at whatever point that comes, that could mean that your losses could be greater than 100%. It's this relative lack of control that keeps me from shorting stocks.

That's not to say that, A, it doesn't have a rightful place in the market. For any healthy capital market situation, you want to have people who are shorting stocks, particularly when you see valuations get exorbitantly high. With that being said, have to balance that with, it's not necessarily that short sellers are shorting stocks, or publishing short-selling reports, out of the kindness of their hearts. They're trying to make money. With that, there could also be some behind the scenes manipulation. You have to keep that in mind when you're hearing about some of these short-selling reports that come out.

But overall, shorting is a healthy part of any market that helps uncover things that the market itself may not have absorbed yet. Really good to see short sellers out there. But, for most long-term investors, just as you mentioned, Matt, the risk is so infinitely high, it's a much safer bet for most investors to stay away.

Frankel: Yeah. Like you said, short-selling definitely adds to the efficiency of the market by allowing people to bet in both directions. It helps control bubbles if an asset gets too highly priced. Short sellers can come in and keep that in check. And, it provides investors with a hedging mechanism. If I own a portfolio of ten stocks and it's gone through the roof, I could short an ETF, like we're about to talk about, to try to mitigate my risk.

If done correctly, it could be a healthy investment strategy. But you really need to be careful. You need to have a clearly defined exit strategy if you initiate a short position. In my Amazon example, if you don't have an exit strategy, it could have gone on forever and ever. It's really important to have a plan going into a shorting position. Like you said, generally, long-term investors are better off just buying stocks and holding them and not worrying about shorting.

Jones: Exactly. We certainly don't knock shorting as an important component of our markets. Even here at The Motley Fool, some of our services use shorting within their portfolios. It's certainly a tool that can be used, you just have to be very, very careful in how you do it.

Now that we've laid the groundwork for what shorting is, let's transition and talk about some of the other ways to profit from a downturn or the demise of a particular stock.

We've discussed the basic strategy of shorting an individual stock. But, as Matt mentioned, you can also now in invest in ETFs that short a particular index. There are inverse ETFs, sometimes called a short ETF or bear ETF, that cover the major indexes like the S&P 500, the Dow, the NASDAQ, as well as a number of small and mid-cap indexes, too. Matt, let's talk a little bit about what a short ETF is and how it works.

Frankel: A short ETF uses derivative instruments to bet against the market. The actual mechanism of it is kind of complicated. The point of an inverse ETF is to deliver the exact opposite of an index's daily performance. For example, if the S&P went up 3%, a short ETF that tracks the S&P would be expected to be down 3%. It's a good way to bet against the market on a short-term basis. Again, it's based on daily price movements.

As our listener said, you're buying a short ETF instead of shorting an individual stock or actually shorting an ETF, that does limit the downside to what your investment is. For example, if I spend $2,000 on shares of a short S&P ETF, and the S&P keeps going up and up, the worst that could happen is I lose my $2,000. That's bad, but it's definitely better than unlimited loss potential.

On the negative side, there are things that skew the odds against you when shorting an index. For one thing, the market definitely has an upside bias over the long term. You've probably heard that over long periods of time, no asset class outperforms stocks. It's absolutely true. This works against you if you're planning on buying a short position as a hedge to hold for a long period of time.

In addition, when you buy a short ETF, you have to worry about fees, just like you would when you buy a mutual fund or regular ETF. To name one example, I was looking at a short S&P right before we started recording this, ticker symbol SH. It has an expense ratio of 0.89%. Already, you're almost losing 1% a year on an annual rate, without factoring in the market's performance. Those two factors -- the market's inherent upward bias and the fees you're paying for buying the ETF in the first place -- both combine to put you at a disadvantage. That's something that investors definitely need to worry about.

The other thing is the daily price movements. Just to give you a basic mathematical example of why that's a bad thing, let's say an investment you own goes down by 50%. Now it's worth half of what you originally paid for it, and it needs to go up by 100% just for you to break even. These daily movements mean your investments need to go up by a lot more than you're losing just to break even, is the basic way to say it.

There's a few things that put you at a disadvantage when shorting. Yes, shorting an entire index definitely limits your downside. But it's still not a great idea from a long-term perspective, is the point of what I'm saying.

Jones: Absolutely. Matt, who would you say, in terms of the type of investors that short ETFs are most suited for, what types of investors should go after that particular strategy?

Frankel: Inverse ETFs and leveraged ETFs that we're about to talk about are best-suited for short-term investors. They're good ways to hedge against short-term trades. If you're buying a stock because you think it's going to go up like crazy in the next month, or you're investing in the S&P, a short ETF can help you hedge against that risk if you use it correctly.

I've used them in the past in a limited basis, but from a long-term perspective, it's really something you need to be careful with. Unless you're very convinced that the market is in a bubble or there's something that's going to happen that's going to drive the sector or whatever you're shorting down, it's definitely a risky strategy if you approach it from a long-term perspective.

Jones: Yeah, absolutely. You've touched on it a little bit, but now, we can actually get into leveraged ETFs. Our listener question wasn't exactly focused on leveraged ETFs, but, if I'm an investor, I see that I could actually get 2-3X returns on the market, or maybe inverse of what the market is doing, why wouldn't I do that? What should I know before I consider diving headfirst into these leveraged ETFs?

Frankel: First of all, it's 3X the profit potential, but also 3X the downside potential. That can magnify really fast. If an index that you're tracking drops by 20% and you're 3X levered to that, your investment drops by 60%. That's the thing to keep in mind -- greater risk, greater reward. But there's a fine line between gambling and taking a calculated risk. Inverse ETFs I would liken to gambling more than investing.

The other thing is the daily price movements that I just mentioned have a double effect when you're talking about a leveraged ETF. This is a simplified example, but, let's say that you buy a leveraged ETF with 3X leverage and the underlying index drops by 30%. You can expect your instrument to drop by 90%. In other words, you would now need to gain 900% in your investment just to break even. It really can amplify your losses, especially over long periods of time.

I would advise any listener who's thinking of buying a leveraged ETF for a long period of time to look at its past performance. You'll see that most of them lose money over time, even when the investors bet correctly, just because this daily price movement puts the investor at an inherent disadvantage over long periods of time. Over short periods of time, these can be useful instruments. But from a long-term perspective, you're at such a disadvantage. The disadvantages I talked about with inverse ETFs are magnified when it comes to leveraged ETFs.

So, keep that in mind, do your homework, and definitely have an exit strategy and a clear plan in mind if you're even thinking about touching one of these.

Jones: Absolutely. You hit the nail on the head. Shorting is risky enough. When you then add in the component of leverage, the challenge of actually making money becomes significantly more difficult in that case, especially when the markets are irrational. You talked about the daily compounding effects. That's the whole key behind this. That's why sometimes, when you see 2-3X returns, you might not actually get that at the end of the day as a long-term investor. Really, the key for using leveraged ETFs is first knowing how volatile those daily price swings are; and secondly, in which direction those price swings are going to go. Both of those factors are nearly impossible to predict, and for long-term investors, nearly impossible to keep up with.

I would say, to reiterate, leveraged ETFs really don't have a place in the portfolio of a long-term investor. If you are going to use them, make sure you have an exit strategy. Consider your stops. And really, I would even throw in, the SEC, the Security and Exchange Commission, has an investor bulletin out on this very topic -- and not just on leveraged ETFs and inverse ETFs, but also in the context of long-term investors. As a matter of fact, the title of it is, Leveraged and Inverse ETFs: Specialized Products with Extra Risk for Buy-and-Hold Investors. So, before you think that Matt and I are both just being curmudgeons on a Monday and want to suck all the fun out of your portfolios, it's not just us. The SEC warns against their use.

Really, I would say, if you are going to use them, certainly read through the prospectus. Many of these funds outline these risks. They tell you pretty much everything that we just told you in the prospectus. You want to check that out. Even in that SEC investor bulletin, they have a special section of what to look for in that prospectus, as well, if you're considering it.

Again, not that it's a terrible thing. There are many different instruments that one can use to profit in the stock market. You just want to be very much aware of the risk involved, really consider your risk tolerance as you go into some of these investments. And, at the end of the day, you want to talk with someone like a Matt Frankel, who is now a certified financial planner, to help you in making that decision.

Matt, any other final thoughts on any of these strategies?

Frankel: The one thing I'd really like to reemphasize is, if you're thinking about buying a leveraged ETF, go back and look at its performance history. The market has roughly tripled since its 2009 lows after the financial crisis. If you look at a triple-leveraged S&P 500 ETF, I guarantee you it has not tripled the market's return in that period of time.

If you look at the performance history of a leveraged ETF before you jump into it, that alone could make you think twice, in addition to the prospectus essentially telling you it's not for long-term investors. So, definitely do your homework, look at the chart, look at the prospectus, if you still decide it's right for you, at least you'll be informed.

Jones: Absolutely. That's it for this week's Financials show. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Shannon Jones. Thanks for listening and Fool on!