The only bull markets to be found these days are: bailouts, fraud, Ponzi schemes and financial meltdowns.  Bill Miller and Warren Buffett’s recent losses, Madoff’s Ponzi scheme, AIG and Citigroup’s misfortune accompanied by misfiring bailouts are all good news if you’ve owned short ETFs.

Short ETFs are the best idea since the S&P 500 SPDRs (AMEX: SPY), the first ever ETF, launched in 1993. Profiting in a down market was previously reserved to sophisticated investors with deep pockets.

Rydex pioneered mainstream short investing when it launched its first short S&P 500 mutual fund (Nasdaq: RYUCX) in 1994. As the first ETF provider to launch short ETFs, ProShares brought short investing from Wall Street to Main Street in 2006.

At first, short ETFs maintained a wallflower like existence as the bull market’s final appearance kept a lid on short ETF performance numbers. October 2007 however ushered in a new era for investors in general and short ETFs in particular.

How do short ETFs work?

Short ETFs, also called inverse ETFs or bear market ETFs, seek to deliver performance that is inverse or the opposite of the underlying index. Depending on the type of short ETF, the performance can be magnified 2x (200%) or 3x (300%). Unlike traditional ETFs which own the securities of the underlying index, short ETFs accomplish their objective by investing in swap agreements, options and futures contracts.

How much leverage do short ETFs provide?

In short, leverage options include 1x, 2x and 3x or 100%, 200% and 300%. To illustrate, let’s take a look at large cap ETFs The ProShares Short S&P 500 (NYSEarca: SH) aims to deliver the inverse (100%) performance of the S&P 500. The ProShares UltraShort S&P 500 (NYSEarca: SDS) aims to deliver twice the inverse (200%) performance of the S&P 500. The newest edition to the family of short ETFs, the Direxion Large Cap Bear 3x Shares (NYSEarca: BGZ), aims to deliver triple the inverse (300%) performance of large cap stocks represented by the Russell 1000 index.

Yes, there is at least one short ETF for each U.S. industry sector. The most popular ones have been the ProShares UltraShort Financials (NYSEarca: SKF), ProShares UltraShort Real Estate (NYSEarca: SRS) and ProShares UltraShort Consumer Services (NYSEarca: SCC). Leveraged, inverse ETFs are not intended for the faint of heart. SRS dropped from $259 a share to $78 a share (a 70% loss) in less than 14 trading days.

According to ETFguide’s database, there are 69 short ETFs tracking everything from domestic and international equities to fixed income and currencies to commodities. Keep in mind that sector short ETFs are often more volatile than broad index ETFs, just as a smaller boat is more susceptible to the ocean's waves than a 2,000 passenger cruise ship.

Over the long-run, inverse and leveraged ETFs don’t deliver precisely on their stated objective. Even though the S&P 500 may be down 40%, the double inverse ProShares UltraShort S&P 500 is up only 60%, not 80% as you might expect. Even with a sophisticated mix of swaps, options and futures contracts, it is nearly impossible to engineer a precise, inverse mirror image of the underlying index.

Respect the leverage

Notwithstanding the tracking error, short ETFs are a powerful tool to hedge current positions and enhance overall ETF performance. As mentioned, the UltraShort Real Estate ProShares lost 5% a day (on average) for 14 consecutive trading days amounting to a 70% loss. Leverage can work for you but leverage can also work against you. Therefore, leveraged short ETFs should be enjoyed responsibly.

Short ETFs and taxes

When investing with ETFs, taxes are usually not a subject that requires special attention. However, due to the unique nature of inverse ETFs there have been some considerable (up to 87%) capital gains distributions. These distributions can be entirely avoided if you don't own the ETF on the ex-dividend date (read related article here). 

How to profit with ETFs

Short ETFs can be used to hedge against current portfolio positions and/or to profit from a down or bear market. If you are not a “bet-the farm” type of an investor, prudence coupled with a general knowledge of where the market is headed are required to maximize profits and minimize losses.

Learn when to use short ETFs >> Sign up for the ETF Profit Strategy Newsletter

The ETF Profit Strategy Newsletter has proved to be a valuable asset for short ETF investors. In the middle of October (with the Dow at 9,500), the newsletter warned of a drop below Dow 7,500 and S&P 780. Investors following this piece of advice could have pocketed a 40% gain in less than three weeks.

A more conservative approach would have been the “teeter-totter” strategy (see image below). Here is an example of the teeter-totter strategy in action. A short position, like the ProShares UltraShort S&P 500, is initiated at Dow 9,500. At the same time, you have a “liquidation plan” firm in mind. The liquidation plan outlines how much of the short ETF to sell at what time.



As the index moves lower, the UltraShort S&P 500 is liquidated in stages. One third is sold at Dow 8,700, the second third at Dow 8,000 and the final third at or below Dow 7,500. As the odds of a trend reversal rise, you reduce your short exposure thus limiting potential losses.