Should you short an index or buy an inverse ETF?

I’ve been getting questions from many of you about how to take advantage of the sharp declines we have had recently in the market.  And declines is an understatement…these are interesting times to say the least!

The question is:

Would it be easier to simply buy an inverse ETF that mimics a specific index or simply short an index fund, such as the S&P 500?

I’m going to show you in-detail… the answer to this question, along with some specific analysis comparing the S&P 500 with an Inverse 3x S&P 500 ETF (daily moves that are three times in the opposite direction of the S&P 500).

First…a brief summary of an inverse ETF:

As you might guess or probably already know, these funds move in the opposite direction of the underlying asset/index.

There are tons of ETFS out there, offered by companies such as ProShares or Direxion and cover every type of sector pr basket of securities you can imagine.  You can buy an ETF that goes in the exact direction of the underlying index, or you can buy an inverse ETF, that moves in the opposite direction of the underlying index.

Also, many of these ETFS are GEARED, meaning they are leveraged by two, two-and-a-half, or even up to three times the underlying asset…including in an inverse direction of the underlying index.

It certainly would be easier to simply BUY an inverse ETF rather than shorting:

  • Perhaps you don’t have a margin account setup and aren’t able to short.  You would have to get agreements setup to be able to setup the margin account to short.
  • Maybe your account size is too small and your broker won’t allow shorting until you reach some minimum account size.
  • Perhaps you have your money in a retirement account like an IRA, where shorting is prohibited.
  • Maybe simply the thought of shorting scares you, since technically you have unlimited risk (no limits to price increase) and limited profit (zero would be the max).  Certainly you can use buy-stop limits to get out of the short sale, but those can get exceeded by massive gaps overnight into the next day.

However, to answer the question of swing trading a general decline over a period of days/weeks/months in a general stock market index like the S&P 500 or a narrowly focused area of the market like retail or oil, the answer is pretty damn clear…

It is better to short than buy an inverse ETF

Let me explain why and then share with you some eye-opening analysis I did of what would actually have happened if you bought one of these inverse ETFs.

For this analysis, I chose the biggest, most well-known index of them all, the S&P 500.  The period I chose to review was the decline of the S&P 500 from the levels of early March of 2020 up until last week, April 10 of 2020.

First, a quick snapshot of the decline in the S&P 500 during that period…

S&P 500 decline from Feb 2020 to April 2020 - Corona Virus Decline You can see the massive Corona-Covid virus caused decline that the S&P 500 has suffered, that started in late  February 2020, had a slight recovery and pause in early March of 2020, and then the bottom fell out, where the index declined sharply overall, reaching a recent bottom on March 23rd.

Along the way towards that decline to the 23rd of March, you can see some huge green up days…which were amazing to live through and watch!

Since the 23rd of March, you can see the index has recovered quite a bit and as of last week, had recovered much of the earlier losses.

My analysis starts from March 2nd, up until this past Friday, April 10, 2020 (which was a holiday).

Looking at this chart, obviously it sure would have been nice to be entirely out of the market and best case, to have profited from the decline!

Back to our question though…to short or simply buy that inverse ETF.  Heck, why not really take advantage of the decline in the S&P 500, let’s get three times the amount of this decline!

That is exactly what I am going to do… look at the ProShares, UltraPro Short 3X ETF (ticker symbol – SPXU).

S&P 500 (SPX) VS. ProShares Short 3X (SPXU)

On March 2nd, 2020, the S&P 500 closed at 3,090.22.

On March 2nd, 2020, the ProShares Short 3X closed at $21.73

Let’s take a look at the performance for the first week:


For this first week, you can see that the S&P 500 went from 3,090 down to 2,972, a decline of 3.81%.  The ProShares Inverse 3X was up 9.53%.  So far…so good!  After all, that is a bit over 3 times the decline.  Someone buying on 3/2 would close out the week feeling pretty smug.

Here is week two:


Now this week is completely F’ed up isn’t it?  The S&P 500 declined 1.29% and our inverse ETF is down even further 8.76%?!!

Yep, take a look at that.  It started the week at $29.45 and ended the week at $26.87.  No doubt about it, instead of profiting from a further decline in the S&P 500, you would have lost a ton of money.  Over that period of one week, the inverse ETF actually down as well.

How could this happen? 

The answer largely lies in trading rule number one…don’t incur large losses.

If you lose 20%, you don’t need to gain 20% to be back to even.  You need to gain more than that…actually you need to gain 25% just to get back to even.

Suppose you buy a stock at $100 and it goes down to $80, you are down 20%.  Gaining 20% on $80, only gets you to $96.  To get back to $100 from $80, you need to gain 25%.

And this my friends, is the pne of the reasons why these inverse ETFs are so dangerous to use to profit from a decline.

There is another reason baked into the design of these inverse ETFs:  They also track the index for a SINGLE DAY.

Take a look at the detail for the ProShares 3x Inverse S&P ETF:

I highlighted in yellow the key reason behind the problem of holding one of these ETFs beyond just a day or two.

  • They reset every single day.
  • They don’t compound their gains from one day to the next.  Essentially you don’t get to keep building on the cumulative effects of each period (day) added up over time.  They reset each and every day!
  • Each day starts over from scratch.

You can see from week two’s performance above, that since the returns don’t build on each other day after day, but reset each day…you would have gotten seriously screwed.

It’s almost akin to running and leading a marathon race, where in the real world if you are running at a faster pace than the rest of the pack each mile, continuing to build your lead, but instead, after each mile you get slapped back to the rest of the pack and will have to run way faster than before, just to get back to the lead you previously held!

For a long term race (such as holding one of these Inverse ETFs for a long time) this is not a race you want to participate in.

Look again at that Week 2 performance.  Do you see how on the 10th & 11th you had roughly equal gain/decline in the inverse ETF?  On the 10th at 15.19% loss from the prior close on the 9th and on the 11th a 14.51% gain from the prior close on the 10th.  You lost ground…even if you had a 15.19% gain the next day, you still would be behind.

Here is a full spreadsheet containing all of the data during the period – SPX vs. SPXU

Take a look at how the wild up days that we experienced whipsawed you further and further behind as each day and week passed by if you had owned the SPXU.

Over all of the weeks from March 2nd 2020 through April 10th 2020, what would have happened if you bought the ProShares Inverse 3x ETF vs simply shorting the S&P 500 index?

The S&P 500 had almost a 10% decline from 3,090 to 2,789 during that period.

Meanwhile, the ProShares 3X Inverse ETF didn’t gain almost 30%, but actually lost about 17%, going from $21.73 down to $18.04 during the same period!

Instead of gaining 3 times the opposite of the S&P 500 decline of 9.72%, the ProShares 3X Inverse had an even bigger loss of 16.98%!  In this volatile period (when it seems that everyone’s interest in inverse ETF’s rises) this inverse ETF actually ended up in the same direction, only down more than twice as much as the underlying index…for the last month and a half it was actually correlated.  🙂

Are there times to buy an inverse ETF?  Sure!  They were designed for very short term trading strategies.  Perhaps you have a huge overnight hold and don’t want take on all the risk of a large downside move…perhaps you buy an inverse ETF.

Otherwise, in cases where you want to swing trade a large, overall move in a certain direction leveraged/Inverse ETFs are really not the way to go.

It pays to read the fine print and understand what you are really dealing with when buying an inverse, leveraged/geared ETF!

Perhaps short or even buy some puts, but to swing trade a decline of a sector or index over a period of days and weeks, trade an inverse ETF with caution!

Good luck with your trading!

 

Glenn

 

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