The Difference Between Short ETFs and Inverse ETFs (and Which Is Riskier)
For traders looking to profit from a falling market , two popular strategies are selling exchange-traded funds (ETFs) and investing in inverse ETFs. While both approaches aim to benefit from downward price movements, there are important differences that investors must understand before deciding which one to use.
Shorting ETFs
Shorting an ETF involves borrowing shares from a broker and selling them on the open market in anticipation of a price drop. The goal is to buy back the shares at a lower price and return them to the broker, pocketing the difference as profit. However, there is the possibility of unlimited losses if the stock price rises rather than falls.
Pros:
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Allows traders to profit from price declines in a specific ETF or market segment.
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Provides flexibility in timing and duration of a short position.
Minuses:
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Requires payment of borrowing fees and interest on the short position.
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Exposes traders to the risk of potentially unlimited losses if the stock price rises.
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Involves the risk of being forced to close a short position prematurely (short squeeze).
Let’s take a closer look at this short squeeze risk with a fresh real-life example. In early 2021, a group of retail investors on the Reddit forum r/WallStreetBets discovered that GameStop shares were being actively shorted by hedge funds. These investors collectively bought and held shares of GameStop, causing prices to rise rapidly. As the stock price soared, hedge funds that were short GameStop were forced to buy shares to cover their short positions, essentially fueling the price increase in a self-reinforcing feedback loop.
The GameStop saga highlights the potential risks of excessive short selling, as short sellers could face theoretically unlimited losses if the stock price continues to rise. For investors interested in shorting ETFs or stocks, this serves as a warning about the dangers of crowded short positions and the power of coordinated buying pressure from retail investors that could trigger a brutal short squeeze.
Inverse ETFs
Inverse ETFs are designed to move in the opposite direction of a specific benchmark or index. For example, if the S&P 500 index falls 1%, the inverse S&P 500 ETF would theoretically rise 1%. These ETFs use derivatives and leverage to achieve this inverse relationship.
Pros:
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Provides an easy way to profit from falling markets without the need for short selling.
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Offers the potential to increase profits through the use of leverage.
Minuses:
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Exposes traders to the risk of compounding losses due to the leverage of these products.
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Typically intended for short-term trading and may not accurately track the underlying index over longer periods.
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Charges higher fees than traditional ETFs.
As a real-world example, consider the ProShares Short S&P 500 (SH) , which provides inverse exposure to the large- and mid-cap companies that make up the S&P 500 Index. SH is not intended to be held for periods longer than one trading day. Let’s say one day the S&P 500 rose 1.07%. This means SH shares were down 1.07%, falling from $14.88 to $14.72 per share . Thus, investors who held positions in SH on a particular day when the overall market was rising would have suffered losses.
Which one is for you
The decision between selling an ETF or investing in an inverse ETF depends on various factors, including an investor’s risk tolerance, investment horizon and overall investment strategy.
Shorting ETFs may be more suitable for experienced traders who have a good understanding of the risks involved and can actively manage their positions. It offers greater flexibility, but also higher loss potential.
On the other hand, inverse ETFs may be a more affordable option for traders looking for an easier way to profit from falling markets. However, the leveraged nature of these products and the potential for increased losses make them riskier, especially for long-term assets.
Ultimately, both strategies carry significant risks and should be approached with caution and appropriate risk management techniques applied. It is critical for investors to thoroughly understand the mechanics, risks and potential benefits of each approach before making investment decisions. To learn more, check to see if you have a Bitcoin ETF in your portfolio.