Inverse ETFs Offer Traders A Profitable Edge On The Downside

Volatility has returned in 2014 after consecutive months of relative calm that has many investors looking for ways to profit on the downside or hedge existing positions.  Advanced traders may be seeking out options strategies or shorting individual stocks to great effect, but another alternative is to consider an inverse ETF that tracks a broad equity index.

An example of this concept is the ProShares Short QQQ (PSQ), which provides investment results that correspond to the inverse daily performance of the NASDAQ-100 Index.   Put simply, this ETF moves in the opposite direction of the popular technology-laden PowerShares QQQ (QQQ). 

Diversification and liquidity are just two advantages of investing in an ETF instead of shorting individual companies.  In addition, you can own inverse ETFs in a retirement account without having to worry about margin privileges being enabled.  This makes them very flexible tools for traders looking to profit when stocks are falling.

In the month of April, PSQ has risen 4 percent as investors have shied away from high beta stocks in industries like biotechnology and social media.  The aggressive ProShares UltraShort NASDAQ Biotechnology (BIS) gained 17 percent over that same time frame.  This leveraged ETF is designed to provide double the inverse daily performance of the NASDAQ Biotechnology Index.  The use of leverage in an exchange-traded vehicle is certainly not for the faint of heart as it magnifies prices moves in either direction. 

Another concern with leverage is how its compounding effect erodes the tracking efficiency of the underlying index over time.  Leveraged ETFs are only designed to track the daily price movement of an index.  Thus, investors should not expect that a 10% move in an index for a 2x leveraged ETF over a three-month time frame is going to correlate perfectly to a 20% return.

Most experts agree that inverse and leverage ETFs should only be used for short-term trading opportunities rather than long-term investment themes.  Investors that are considering these tools should carefully consider the risks and research them thoroughly before opting to employ them moving forward.