This morning, investors were cautious as spiking infection rates in Europe have prompted governments to tighten restrictions. Austria announced earlier today that it would re-impose lockdown measures amid rising hospitalizations and death rates. Germany and a slew of other nations are also increasing restrictions in an attempt to slow the spread.
So far this week, the Nasdaq and S&P 500 are on track for modest gains, up 0.8% and 0.5%, respectively. Meanwhile, the Dow is down 0.6%, on pace for its second negative week in a row.
Challenges for the stock market could arise at any time without warning. The situation becomes especially fragile when stocks are in record-high territory like they are right now. Unfortunately, no crystal ball can tell us what the future holds. That’s why investors need to educate themselves about the tools available and prepare themselves for any circumstance.
That’s why we’re using this opportunity to discuss an essential trading tactic that those in the know use to benefit when things get ugly. Many of the Wall Street pros consider this a more logical alternative to short-selling as it typically carries less risk. It’s an important tool to have in your tool kit in times of heightened volatility. Read on to learn how to put this valuable tactic into play.
Traders who are looking to benefit from sliding stocks often turn to short-selling. The main risk of traditional short-selling is that while profit is capped (a stock can only fall to zero), the risk is theoretically unlimited. Of course, other tactics can be used to cover a position at any time, but with a short-selling position, inventors are at risk of receiving margin calls on their trading account if their short position moves against them.
Inverse or “short” ETFs are another option that allows you to profit when a certain investment class declines in value. Some investors use inverse ETFs to profit from market declines, while others use them to hedge their portfolios against falling prices.
Over short periods of time, you can expect that the inverse ETF will perform “the opposite” of the index, but a disconnect may develop over longer periods of time. Inverse ETFs will decline as an asset appreciates over time. For that reason, inverse ETFs typically are not seen as good long-term investments. Furthermore, frequent trading often leads to an increase in fund expenses, and some inverse ETFs have expense ratios of 1% or more.
When approached correctly, inverse ETFs can be excellent day-trading candidates and highly effective short-term hedging tools. There are several inverse ETFs that can be used to profit from declines in broad market indexes, such as the Russell 2000 or the Nasdaq 100. Also, there are inverse ETFs that focus on specific sectors, such as financials, energy, or consumer staples.
With $4 billion in assets, the ProShares Short S&P 500 (SH) is the largest inverse fund by value. Commonly used by investors as a hedging vehicle, the fund strives to deliver the inverse performance of the S&P 500 (SPX). If you’re concerned about the stock market falling, then this fund that moves in the opposite direction of the largest 500 U.S. corporations is the simplest way to protect yourself. It’s important to note that SH is designed to deliver inverse results over a single trading session, with exposure resetting on a monthly basis. Investors considering this ETF should understand how that nuance impacts the risk/return profile and realize the potential for “return erosion” in volatile markets. SH should definitely not be found in a long-term, buy-and-hold portfolio. The fund comes along with an expense ratio of 0.9%.
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