Inverse ETFs: What They Are & How They Work

“Inverse ETFs: What They Are and How They Work” are important for investors to know if they are interested in using contrarian strategies when stocks start to drop and are expected to continue doing so.

In this article, “Inverse ETFs: What They Are and How They Work,” you will learn about inverse ETFs and how to use them. The following will be covered:

• What an Inverse ETF is and how it works
• The Types of Inverse ETFs
• Benefits & Risks of Inverse ETFs
• Bottom Line: Should you invest in Inverse ETFs?

This article, “Inverse ETFs: What They Are and How They Work,” provides information about such ETFs that stock investors can use when considering what investment decisions they want to make.

What is an Inverse Exchange-Traded Fund (ETF) & How Do They Work?

An inverse ETF is a fund that uses financial derivatives such as a futures contract to profit from a market decline. In a futures contract, an investor agrees to buy a security at a specific price and time. Essentially, investors who buy inverse ETFs are betting on the stock market going down.

Oftentimes, inverse ETFs are compared to what short-sellers do because they are also borrowing securities, selling them and hoping to buy those securities back at a lower price to profit from that downward price movement. The profit is the difference between the sell price and the purchase price after the price decline. If the market declines in favor of the investor, the inverse ETF is intended to increase in value by the same percentage.

The ProShares Short S&P 500 ETF (SH), for example, is the second-largest inverse ETF. It tracks the inverse of the S&P 500 and gives investors “reverse” exposure to large-cap stocks in the United States.

Investors who are betting against this index doing well potentially may want to add this ETF to their investment portfolio and monitor it closely. Depending on the specific inverse ETF, exposure to the index is reset either daily or monthly. SH, for example, is reset on a monthly basis.

Types of Inverse ETFs

So far, we have discussed only one type of inverse ETF, which is the conventional type that tracks and shorts an index on a one-to-one basis. However, there are many inverse ETFs that also short indexes on a two-to-one or even a three-to-one basis. Similar to the concept of leveraged ETFs, there are leveraged inverse ETFs in which financial derivatives are used to compound the potential gains of an investor.

For example, ProShares UltraPro Short QQQ is a -3x leveraged inverse ETF that tracks the Nasdaq-100 index. If the Nasdaq-100 is down 2% on a given day, the return for an investor holding that short ETF would have a profit of 6%.

Furthermore, there are also inverse ETFs that track specific industries. Thus, if investors believe that there will be a market correction in the semiconductor industry, for example, they can buy SOXS, which is a -3x leveraged inverse ETF that tracks the ICE Semiconductor Index.

Below is a short list of -2x and -3x leveraged inverse ETFs:

• SDS – ProShares UltraShort S&P 500 (-2x)
• SPXU – ProShares UltraPro Short S&P 500 (-3x)
• SPXS – Direxion Daily S&P 500 Bear 3x Shares (-3x)
• TZA – Direxion Daily Small Cap Bear 3x Shares (-3x)
• SDOW – ProShares UltraPro Short Dow30 (-3x)
• QID – ProShares UltraShort QQQ (-2x)
• SOXS – Direxion Daily Semiconductor Bear 3x Shares (-3x)
• DXD – ProShares UltraShort Dow30 (-2x)

Benefits and Risks of Inverse ETFs

For investors who closely monitor and predict the decline in the stock market’s direction, inverse ETFs can definitely be a powerful tool for them. However, retail stock investors must understand that inverse ETFs are generally used as hedging tools rather than long-term investments like most conventional ETFs.

For example, if an investor is holding a position in the electric vehicle manufacturer Tesla (NASDAQ: TSLA), and he expects the stock to fall, SH could be bought to use an inverse ETF that shorts the S&P 500. If the investor is correct, the acquisition of the inverse ETF will have helped them reduce their losses from TSLA. Furthermore, the purchase of SPXU, which is a -3x inverse ETF for the S&P 500, in the same situation would have reinforced the safety net against the decline in the stock and perhaps even resulted in a net gain.

However, incorrect predictions could be costly, especially if leveraged inverse ETFs are involved. Using the same example as above, imagine if SPY went up 10% in one day, and an investor held a position in SPXU. That would lead to a 30% loss, as well as a net loss of 40% compared to the market.

Despite the market being up, the investor still lost significant money. These risks are compounded by the fact that the stock market historically goes up far more frequently than it goes down.

This makes inverse ETF investing much more difficult than regular investing. Thus, inverse ETFs are a high-risk, investing tool for investors who believe that the market will follow a downward direction on a given day, especially if leveraged.

Bottom Line: Should You Invest in Inverse ETFs?

Inverse ETFs are funds that short an index and can be a helpful tool for hedging against potential losses or profiting from the market when it’s doing badly. Like any investment, investors must monitor inverse ETFs very closely to time their exit well to prevent losses.

These ETFs are short-term investments and often are used by professional, experienced investors because of the level of risk involved with trading them. It requires much research and experience to correctly predict the direction of a market and it still can go the opposite way. Therefore, retail investors who don’t want to spend time doing their research on a given index or are uncomfortable with the risk should avoid investing in inverse ETFs.