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Buying short ETFs to profit from a falling market

with 2 comments

Drowning,not waving.jpg_thumbShort positions are what you need in a falling stock market. There is nothing else in the equity universe that will perform inversely to the market, and that is what you have to do to profit from a stock market correction or crash.

Technical indicators have been stacking up to the ceiling to confirm an end to the recent rally as the Dow Jones topped the psychologically important 10,000 barrier. Fundamental indicators show that markets should never have gotten this high, and are good reason to think governments will not be interested in preventing a correction now.

Short ETF heaven

So cast an eye over the three top performing exchange traded funds last Friday: EDZ Emerging Markets Bear3X +13.33%; FAZ Financial Bear3XNew +12.51%; Powershares DB Crude DTO +11.16%.

Of course you need to be pretty brave to invest in these ETFs considering their 12-month performance: EDZ -89.6%; FAZ -94.1%; and DTO is down 73.3% from its March high. And these figures are after the recovery last week.

But that is also the beauty of these short ETFs. Imagine that the stock market had just crashed. Would you not look carefully among the wreckage for good companies with unreasonably low valuations? And would you not want to buy them just as the market seemed to be almost sure to recover sharply?

That is what you are getting with these ETFs, and there is quite a universe of short ETFs to choose from. Sure there might be third party risk on some of these, so diversification is ever the wise policy if you choose to invest in this asset sub-class.

Normally I must admit I would shy away from leveraged funds. They do have the unfortunate quality of magnifying losses as well as boosting upside potential. They do not always perform their market tracking function very well. And if you stay in them for long the fee structure works against a patient investor, so they are not for buy and hold.

Falling market

But for capturing the profit potential of a market reversal, especially what should be a big one then short ETFs seem ideally placed.

It would hardly be surprising if the biggest stock market rally in history – which is where we are now coming from – is not followed by the biggest correction. Heightened volatility in financial markets is one of the nasty side-effects of the massive government interventions that we have witnessed over the past year.

It is a devil of course if you get it wrong, so do not put all your eggs in this basket. But anybody long on stocks ought to consider this. Bond funds will also do well and the US dollar, otherwise all other asset classes including gold will come down with global stock markets in a big sell off, so consider hedging them too.

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Written by Peter Cooper

November 1, 2009 at 8:52 am

2 Responses

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  1. A word of extreme caution regarding highly leveraged ETFs (i.e. ETFs with a 3X leverage factor):

    For Very Short Term Trading ONLY
    These 3X ETFs, such as EDZ and FAZ, are meant to be for very short term trades. The longer you hold these ETFs, the more likely the possibility that you will lose. The reason for this is because of the way that the algorithms are constructed to produce a “3X” factor.

    A Practical Example:
    In other words, over the course of the next 6 months, let’s say the ” unleveraged” underlying investment (e.g. oil, or financial firms, or whatever) experiences volatility (i.e. daily gains and losses of 1% or 2% or more), then goes down 100% but eventually goes up 100% over that time frame, you will not “break even” with your investment in the 3X ETF. You will be at a loss of about 15% or so (depending on the formula used).

    obewon

    November 1, 2009 at 8:23 pm

  2. Those that bought FAS and UPRO were rewarded pretty nicely these last 6 months. Perhaps the time has now come for those on the losing end to make some money but with the invisible hand at play we don’t know what the next draw will show.

    Too bad there aren’t any ETF’s available on DFM or shorting. Would have been easy money with today’s bloodbath. Falling oil prices along with the market in the US and Asia don’t usually digest too well in the Gulf States.

    Ed Note: Yes down 5.5% today on the DFM – inflated emerging market equities must be the most vulnerable to the correction. Down to a new bottom?

    Andy

    November 1, 2009 at 4:04 pm


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