Boning Up on Inverse ETFs for Inverse Markets

Inverse ETFs

With the prospects of an extended bear market on the horizon, investors would be wise to rethink old strategies that end up being completely inappropriate for these markets.

If you ask any investor why they invest, and they thought about their answer at all, it surely would be that they are looking to make money with their money. We call that return on investment, and this applies to anytime we stake money on something. Investors and traders use this to measure their progress. Business people and companies do as well. Even professional poker players calculate this out as part of their doing business.

No one would disagree with this, even though this calculation alone isn’t sufficient to know what to do. If we had to stake $1 but won $100,000 to play a single round of Russian Roulette, we’d have to be pretty desperate or crazy to want to play this game, because a 1 in 6 chance of getting shot in the head would just be seen as too risky by the great majority of people.

The same would be the case if we took everything we saved for retirement and bought a binary option with it, double or nothing our million dollars or whatever amount we have saved up. Having two million would be mighty nice, but losing our life savings would hurt more than this extra million would help, and just about anyone would decline such an opportunity.

We could do something like this trading derivatives as well, futures or options or even contracts for difference, and especially those because some places let you bet 1000 times more than you have, where a move of only a tenth of a percent in the asset will wipe you out. It’s not just about how much we make, it’s how much we can make with an acceptable level of safety, called risk management.

This is why we always mention the two together, return and risk, and if you are a trader, paying enough attention to this is not optional. The reason why traders fail at such a high rate isn’t because they are not making enough return, although that may be the case as well from poor decision making, it is because they haven’t learned to manage risk properly.

Investors who are trading unleveraged do not worry about risk of ruin calculations like traders do, who generally will use some sort of leverage, and therefore investors can be lulled into a false sense of security, thinking that they don’t have to worry about risk all that much and they can just put 40% of their money in bonds or some other asset and have this part taken care of.

It is not enough to look at both risk and return, as we need to understand enough about both and how they factor into good investing to be able to conduct ourselves in a manner that is consistent with our goal, which is to maximize returns without taking on excessive risk.

This is a very broad topic which we discuss in many of our articles, but in this one we want to focus on how we approach this combined goal when things aren’t moving ahead the way so many people prefer them to be. Investors have a strong bias towards the long side, so much that they may not even think of investing as anything else but holding long positions over time, and such a thing can serve them reasonably well as long as prices keep going up.

We want to start by looking at a few bear markets of the past to get a taste of what sort of beast we may encounter, and even though the market, which most people refer to as the S&P 500 index, has finally made it back to an all-time high earlier this week, stock indexes don’t always just go up with little breaks in between like the 6 months we took to get back to where we were in February.

Just about everyone is familiar with the big one, the crash of 1929, but people who weren’t around back then or even those who were but really don’t pay that much attention to stock indexes may not realize that it wasn’t until 1956 where we got back to even on an inflation-adjusted basis.

That’s 27 years of waiting, and while there was some ups and downs throughout this, you weren’t going to benefit unless you actually timed the moves. Investors who think they can just ride out long bear markets without having to worry about timing need to look to the past to see just how long these things can go on at times.

The next major bear market was in 1968, meaning that we got back to the green from 1956-68 and then the bears moved back in for a while. It wasn’t until 1992 that we got even from this move, and this time we only spent 8 years in the green before the crash of 2000 hit.

It wasn’t until 2015 that we got even from that one, and we’re now 5 years into this new growth period, although how long it continues is anyone’s guess. If we add these 5 years to the 8 years and the 12 years, we end up with 25 years of moving ahead and 66 years of moving down or trying to get even. If we just want to limit our view to the 21st century, it has added up to 5 years of growing and 15 years of catching up, so this isn’t just a matter of this phenomenon being ancient history.

Net of inflation, this index has gained 487% between 1929 and 2020, a measly 5.3% per year on average, at least if you held it all this time, although this means that if you were 20 at the time you would be 109 today. Over the last 20 years, a more realistic number to use, we’ve gained 49% net of inflation, or only 2.4% per year over this time, an even worse return.

Becoming so enamored with the long side and just burying your stocks in the back yard for decades isn’t all that exciting, and although stocks can have a pretty nice run for quite a while, like the 10 years between 2009-19, the path to the promised land has been anything but straight up the mountain. People fall off it every so often and fall hard, and this should at least make us wonder if there isn’t a better way to climb these mountains.

If We Want Better Results, We Have to Seek Them

The treasure chest buried in the yard strategy is not a very good one, both in absolute and relative terms, and we at least owe it to ourselves to consider taking off any wedding rings that have us married to our stocks on the long side and see what else might be out there that may be better.

We need to do the opposite of what these folks do, and instead of trying to put our investments into time capsules, we instead need to be on the lookout for opportunities at all times. Something doing better than the S&P 500 on the long side, the Nasdaq perhaps? Maybe both aren’t doing that well on the long side, but why not shift horses and go with the flow?

There are therefore two things that we need to be aware of when we manage our positions, which are to be in the right investments and be going in the same direction that they are. If something wants to go down, you should not be trying to go in the other direction or you will hurt yourself.

By doing this as best as can, this will cover us both on the return and the risk side. We’re already going after the best return we can, but by doing this in both directions, this also provides the risk management that we need as well.

It’s pretty easy to understand why. If we are willing to bet in both directions, this means that moves against us in a position represent an opportunity to us to go the other way, where we jump off this train when the situation starts to not warrant being on it, and then board a train in the direction that price is moving.

People that hold through any pullback bear the most risk, the maximum amount, because they hang around for the maximum. Investors may instead have a certain amount that they are prepared to lose, perhaps a third or a half, and this defines their risk.

Investors do not approach this in a structural way like a good trader would, always defining risk even before getting into any trade. Traders need to pay close attention to risk to even survive, but investors need to be paying attention to this as well, as if not, we are neglecting one of the two essential components of good investing, taking care of both return and risk.

Seeing our positions reverse gives us twice the reasons to get out than if we were just looking to go long or flat, and beyond the tipping point, the opportunity cost of not being on the short side gets added to the actual loss that occurs at the same time.

The ideal here is to maximize return safely, and going both long and short gives us both the opportunity to make more money and do so in both bull and bear markets, which means the potential for better returns. By not hanging around for too long, by defining our risk tightly enough, as this plan actually requires, we’ve also limited our risk and have done so in the maximum way that is reasonable, as you don’t get any more incented to get out than protecting against risk and adding to your return as the reversal unfolds.

The bias in the investing world isn’t just decidedly toward the long side, it is overwhelmingly so. There is a fair bit of shorting action that goes on but this is almost all from traders, and you can’t short safely without approaching shorts as traders would. Most investors want to be in it for the long term and don’t want to do much if anything to help themselves, but shorting can’t be done the same way that going long can because the longer-term bias of the market is in the other direction.

We therefore have to open our minds enough to see that there really is no essential up or down with stocks, just like there isn’t an up or down with the Earth, it’s all about your perspective. We need to be thinking like traders do about our investments, where our task is to do our best to take advantage of probabilities. If something probably will go our way, we want to be in it, where if it will probably go the other way, when it’s more likely that we will get beat for a while than not, it’s not even rational to choose the beating.

Most investors have heard of people shorting stocks and usually see this as too risky for their blood, feeling both the pain and the fear when they see how these trades can go wrong, with people shorting a hot stock like Tesla. Tesla hits so hard that one punch can knock you out if you are fighting from the wrong corner, and perhaps have taken too many blows to the head in former fights to know any better than this, to even think of shorting something like this apart from intraday trades managed very tightly.

You can trade anything you want intraday, even something as crazy as Bitcoin, but that’s only because you can give this such a tiny leash. The longer you expect to hold this, the longer the leash you need, and this dog can run. We need something considerably tamer than this to be on the short side, and we could even argue that some horses are just too wild for investors on the long side as well, those who don’t have the skills yet to ride it start with less powerful mounts.

Inverse Index ETFs are Ideal for Bear Stock Markets

It’s actually better for investors to stick to ETFs for their short positions, as they are more telegraphed and aren’t anywhere near as wild as the more volatile stocks. You also don’t need to worry about borrowing stock and especially pay premiums to do it, and some of these premiums can be very expensive.

We don’t just want any ETFs though, we should stick to ones that trade on the futures market, the major indexes. Of these indexes, the Nasdaq has been the better and more reliable performer for some time, so would represent the best choice, and the best choice for anyone, not just those with preferences that match. If our preference isn’t to make money, and we allow other preferences to substitute for it, we will make less money.

This does not necessarily mean that you have to play the Nasdaq on the way up, and if you prefer to go with stocks instead, and when going short the Nasdaq starts looking like a better idea, you just switch over to that. A real benefit of going with futures-based ETFs is that nothing is ever borrowed or even owned by anyone in this market, so you don’t have to pay anyone to borrow anything.

You may not pay it, but your fund will, and this eats at your return. This is a big reason why you see some inverse ETFs not do anywhere as well as you might expect if you had a move of a certain size on the long side.

You do not have to have strong trading skills to benefit from this strategy, although the better you can trade, the better you will do of course. We are not talking about looking to trade every wiggle, unless you want to become a trader of course, but the sort of things that need to attract the attention of investors are moves like the fat one the market served up for us back in February.

These were easy calls to make, and we did call both the crash and the recovery with remarkable precision, but the getting out part wasn’t hard at all because the fear level was so high back then that you could cut it with a knife. This one didn’t even require looking at charts, as this fear was so substantial as all you needed to do is see things start to drop and you should have easily known that this was no time to be long.

Knowing when to get back in when the tumble down the hill subsided did take more skill to know when to switch back to the long side, but the prevailing conditions told the story this time as well. This was a panic driven selloff, causing people to dump their stocks, even ones like Amazon, with reckless abandon, and this was all clearly overdone and a rebound was in the works.

We rebounded more than many had thought, and no one in fact expected the market to fully recover as quickly as it did, but being long after the dust settled was an easy call and had you riding the right train for as far as it wished to go.

What we are looking to achieve as investors playing this way is to manage the bigger risks more than anything, taking the real lemons that sour the countenance and portfolios of those married to the long side and making a sweet and refreshing beverage out of them instead. Others may stand tight and take the full beating that the bears have in store, where we instead have bear spray and can use it to never again be frightened of these creatures, which is very empowering.

Investors can choose inverse ETFs that track the Nasdaq with either one, two, or three times leverage. The ones with the additional leverage are for more skilled investors, and even though more casual investors can step up and take on the additional risk, all of these plays require that we pay close attention to not letting our positions run away from us, and you have to pay extra attention if you are leveraged.

We all have to put our investor hats in the drawer when shorting, and realize that we need to only be along for the ride if the outlook remains bearish, and when it starts to turn bullish, like when we bounced off the lows and there was now real potential to recapture what was sold off by way of the panic, this did turn the tables and we need to recognize these things and not fool around being on the bear side when the bears go back into their den.

We actually favored a leveraged treasury play at the time due to it having a better risk to return ratio, and bonds were hot back then and we achieved better returns than going with an unleveraged inverse ETF position, and while the leveraged versions were very competitive returns wise, the risk was so much higher than in a leveraged treasury ETF where the risk then was low, and no one was expecting treasuries to sell off in the midst of a stock market panic, with the downside being that the rally will slow down and it would then be time to go.

This is why we should be looking at other assets besides stocks during a stock bear market, to decide what the best move may be, and we looked at shorting stocks as well as going long bonds and gold. Bonds just ended up being the best pick based upon risk to reward, with both gold and inverse stock ETFs being riskier, but the riskiest position by far would have been to stay long stocks, and any choice would have been considerably better than just getting creamed.

By the time stocks started falling and money started flowing back into them, the bond trade started to level off and now became the inferior play comparatively, and it was time to leave this hotel and go back home again to the long side of stocks, and the whole thing turned out beautifully, but only because we were directing this play and not just standing on the sidelines and watching and grimacing like most people did.

You can’t look to people who dispense investment advice to get good guidance when these things happen because these people are really out of their element, as this requires much closer direction than these people are trained or equipped to manage. We are on our own here, but the good news is that this isn’t difficult at all to help ourselves considerably, we just need to be paying attention and not trying our best to just ignore what is going on and hoping that it goes away soon, like people who go into the turtle while being kicked on the ground.

Turtles have a hard, protective shell, and don’t have to run away, but we don’t. All investors are concerned about risk, and rightly so, but just being concerned isn’t close to being enough, we also need some sort of plan to go with it besides being afraid of things and upset when these things happen.

This does not have to be complicated at all, and people can even use their fear and optimism levels to guide them, or the general outlook on the street, where going over a certain level of concern should have us respecting these things and not trying to get too cute about trying to buck these trends and thinking that it will all come out in our favor in the long term.

The damage we take during these times does matter, and does leave an indelible mark upon our portfolios, especially these bigger moves where we could have easily avoided 25% of this move down and even booked profits instead during this time. This game is about making money. Understanding this is the first and biggest achievement on the road to real success, but we have to throw out all the rotten ideas that investors keep under their pillow such as we need to be on the long side in good and bad weather, and that we can’t profit from bear markets as well.

With the future so uncertain, as we await the impact of the coming U.S. election and everything else that is on the table, we need not fear the bears if they come again, as long as you are willing to make friends with them.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: [email protected]

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