Make Money with Market Declines

3 Inverse ETFs to Play the Market Chop

The most recent American Association of Individual Investors reported Bullish sentiment stood at 18.9%. This cautious outlook has been reflected in choppy market conditions. 

Sentiment data can signal extremes and potential tops and bottoms in the market. We want to be careful reading too much into one data point. 

What the survey does highlight is the uncertainty market participants face. Supply chain issues, inflation, monetary policy, and geopolitical turmoil all play havoc with investor confidence.

These are difficult conditions for long-only funds. Investors are looking for ways in which they can profit when the market declines as well as rallies. This leads to an uptick in the use of Inverse Exchange Traded Funds (ETFs).

Inverse ETFs are used by contrarian traders looking to profit from declines in a certain asset class. Recent data from Sentiment Trader highlights increased usage of these instruments:

These are risky instruments and investors should understand basic principles. Short ETFs use financial derivatives such as options or futures to target the desired performance and return. They can be levered up to create 2x-3x the move of the underlying index or sector it is tracking.

One aspect investors need to be aware of is the decay associated with these vehicles. As a geared product with daily resets, leveraged ETFs are designed for short-term trading and are not a long-term investment vehicles.

Expense Ratios tend to run high because fund managers need to roll over instruments. Due to the compounding of daily returns, holding periods of greater than one day can result in a return that is significantly different than the target return. 

Imagine a fake index, “XYZ”, and 2x leveraged ETF “XXX” (2x Long XYZ) and “YYY” (2x Short XYZ). If XYZ starts at $10 on day 1, moves to $11 on day 2, and back to $10 on day 3, then XXX goes from $10 to $12 to $9.82. YYY goes from $10 to $8 to $9.46, In other words, both go down on a sideways XYZ move. That effect is always operative and why most Leveraged ETFs go down over time, regardless of the market. It is a time decay effect. The higher the leverage, the greater the potential decay of valuation due to the structure.

Investors should only use these instruments if they are comfortable understanding this concept. It is a short-term trading vehicle that should be used daily not as a buy and hold strategy in a portfolio. 

Here are three highly liquid ETFs that a savvy investor can use to help hedge against losses and play the market chop.

Axe Chopping Wood

ProShares UltraPro Short QQQ (SQQQ)

SQQQ provides three times leveraged daily downside exposure to a modified market-cap-weighted index of the largest non-financial firms listed on the NASDAQ. This is a great instrument for traders with a bearish short-term view on large-cap technology names. 

ProShares creates this exposure by using swaps on the NASDAQ-100 ETF (QQQ), swaps on the index itself, and futures. The product is designed for daily use, not over a long-term horizon because expenses and decay will quickly eat into returns.

Assets Under Management is approximately $3 billion and the fund trades approximately 90 million shares a day which creates plenty of liquidity for traders. 

The expense ratio is high at 0.95% as the fund strategy requires occasionally liquefying contracts before optimal points. 

ProShares Short Ultra Short S&P 500 (SDS)

SDS provides a 2x downside exposure to the market-cap-weighted S&P 500. The ETF is designed for traders with a cautious short-term view of U.S. large-cap companies. 

It seeks to profit from market declines, help hedge against an expected decline, and underweight exposure to a market segment. 

The fund holds swaps against the S&P Index as well as treasury bills to create liquidity. 

The ETF has returned 12.5% year-to-date. The longer-term returns are not as enticing with 1-year seeing a decline of 20%, 3-year -36%, and 5-year -31%. This highlights that time decay effect.

The SDS has $794 million in Assets Under Management. Average Daily Share Volume sits at 13.7 million and provides plenty of liquidity for traders. The Expense Ratio is high at 0.91%. 

Direxion Daily Small Cap Bear 3x (TZA)

TZA offers (-3x) daily inverse exposure to U.S. small-cap Russell 2000 index. The underlying index holds the lowest 2000 securities pulled from the Russell 3000. 

The fund uses ETF and index swaps to get its inverse exposure. 

Assets Under Management stand at $365 million. Average Daily Share Volume is 15 million. Again, plenty of liquidity should be paramount when trading bearish instruments. The Expense Ratio is high at 1.07%. 

The year-to-date return is 25.89%. The longer-term returns are less impressive as it has declined 54% over 3-years and -45% over a 5-year period. 

Other Inverse ETFs to consider include PSQ, QID, SH, and SPXU.