If that investor had shorted the index by selling an ETF, they’d have generated a profit over that three-day period.
Leveraged ETFs use similar instruments as inverse ETFs. In fact, you can buy leveraged inverse ETFs. Be aware, however, that they can be very bad choices in volatile markets due to their potential for volatility loss. The mechanisms they use to provide inverse returns are only good for very short periods or periods where investors expect steady declines.
When should you buy an inverse ETF?
Inverse ETFs work best in the short term. Consequently, they’re best used as a short-term hedge on an existing position in your portfolio or to make a directional bet on the market.
For example, if you believe the Fed will announce an unexpected monetary policy at its next meeting that will send markets down, you can buy an inverse ETF around that meeting. (Note that this is pure speculation and isn’t advised.)
Perhaps you also hold a lot of tech stocks that are all set to report earnings around the same time. You might buy the Direxion Daily Technology Bear 3x Shares (TECS +4.26%) before they report and sell after the report to hedge your investments, putting a cap on the downside and upside of unexpected earnings results.
However, since the Direxion Daily Technology Bear 3x Shares is leveraged, you would likely only want to buy a small position in the ETF. That leverage also means that volatility loss could play a significant role in your overall results. So if the early results are bad but companies later report good earnings results, it could ruin your hedge.
Using inverse ETFs in your portfolio is an advanced strategy. It’s very important to know when to enter and exit a position in an inverse ETF because they can move against you very quickly. And, as previously mentioned, even if you’re directionally right, volatility loss can destroy your profits, so keep the holding period to a minimum.
Related investing topics
