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Bear Market Insurance

March 17, 2010 | About:
Last week marked the one-year anniversary of the market's March 9 bottom. Since then, the S&P 500 has risen from 676.53 in the darkest days of the financial crises to a close of 1159.46 on Tuesday. That's a whopping +71% gain in just over a year.

Now what?

Stocks certainly could continue to move higher. But they've come a long way already and today's economy is still fraught with uncertainty. Given these circumstances, it might be worthwhile to consider adding something to your portfolio that is virtually guaranteed to go up when the market goes down.

Fortunately, there is an easy way for investors to bet on or hedge against a down market: Inverse ETFs

An "inverse" ETF is an exchange-traded fund designed to rise when the market falls. Introduced in 2006, these investments enable investors to easily benefit from the decline of a market index or benchmark.

Don't be scared off by the complex, mathematical-sounding name. Investing in inverse ETFs is very similar to investing in regular ETFs.

They're similar to closed-end mutual funds in that they're traded on major stock exchanges and can be brought or sold any time just like a stock. (Mutual funds can only be bought or redeemed once a day.)

The difference with inverse ETFs is the content of their investments. While regular ETFs generally invest individual securities and indexes with the intention of profiting from a rise in the market or a certain sector, inverse ETFs invest in derivatives instruments and strategies that are designed to appreciate when a given benchmark goes down.

You can find inverse ETFs associated with virtually every important broad market index or industry sector (such as financial or healthcare). If you think an index or benchmark will go down, you buy shares of the corresponding ETF. When you think a downturn has run its course, you sell it.

Specific Inverse ETFsInverse ETFs that focus on the broader market indexes include Short S&P 500 ProShares (SH), Short Dow30 ProShares (DOG) andShort QQQ ProShares (PSQ) which focuses on the Nasdaq 100. These ETFs track the inverse daily performance of the underlying indexes. In short, they are designed to go up in value by about the same amount as the index goes down.

To be sure, inverse ETFs are not without risk. While they appreciate when the market goes down, the reverse is also true. These investments will lose value in a rising market. Also, given the complicated and sophisticated derivatives employed to affect the strategy behind inverse ETFs, there is no guaranteethat they will achieve the desired effect. They could exaggerate a market move or not completely capture the inverse performance of a given benchmark.

One notable inverse ETF is the UltraShort S&P500 ProShares (SDS). This is a turbo-charged inverse ETF that uses leverage to track twice or 200% of the inverse daily performance of the S&P 500. All well and good when the market is falling, but if the market goes up, this security loses value in a hurry.

However, when used properly, inverse ETFs can mitigate the negative effect of a falling market on a portfolio and help balance out returns in an uncertain period.

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http://www.streetauthority.com/

Disclosure: Tom Hutchinson does not own shares of any security mentioned in this article.

About the author:

Street Authority
StreetAuthority, LLC is a research-intensive financial publishing firm that aims to level the playing field for small investors by giving them access to the ideas and insights of some of the country's top investment researchers, analysts and writers. Although we specialize in income and international investment research, we publish a wide variety of newsletters that are geared towards helping EVERY kind of investor profit from today's volatile marketplace. Visit StreetAuthority.

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Comments

DaveinHackensack
DaveinHackensack - 4 years ago
Instead of buying a short index ETF, you could buy puts on a long index ETF. Checking Portfolio Armor just now, the cost of buying put protection against a greater-than-20% decline in the value of a SPY position for six months is about 1.27% of the position value, and the cost for the same protection on a DIA position is about 1.25%.

Alternatively, you could consider hedging your specific holdings, or adding short exposure by shorting or buying puts on individual stocks you are bearish on.

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