Best Inverse ETF Trading Strategy

The Best Inverse ETF Trading Strategy: Backtesting, Trading Guide, and Execution

An inverse ETF trading strategy is a trading method that seeks to profit from declining market conditions by buying inverse ETFs — exchange-traded funds that are designed to move in the opposite direction of the underlying index. The best inverse ETF trading strategy would depend on the underlying index or sector being tracked, expense ratio, liquidity, and historical performance.

Inverse ETF trading seeks to profit from declining market conditions by allowing investors to short an index or sector. It can be used to hedge against market risk, to trade a bearish bias on a specific sector or index, or as a tactical trading tool. An inverse ETF trading strategy can be useful for investors looking to manage market volatility. But what does inverse ETF trading strategy mean, and how do you find the best inverse ETF trading strategy?

In this post, we take a look at the best Inverse ETF trading strategy (if it exists). We end the article with a backtest and find out if inverse ETFs are useful and how you can trade them (if possible).

Key Takeaways:

  • Inverse ETFs are designed for short-term trading due to costs and daily rebalancing.
  • Effective inverse ETF trading requires understanding market trends, selecting the right ETF, and managing risks.
  • Long-term holding of inverse ETFs is not recommended because of their structure and the effects of daily rebalancing.
  • A successful strategy involves careful market analysis, diversification, and timely execution based on economic indicators and technical analysis.
  • Backtesting reveals inverse ETFs are not effective substitutes for direct short positions due to performance divergence over time.

Introduction to inverse ETFs

Inverse ETFs are exchange-traded funds that aim to provide returns that are opposite to the performance of a specific index or sector. They are designed to move opposite the underlying benchmark, allowing investors to profit from declining market conditions. These ETFs can be used for a variety of purposes, including hedging against market risk, expressing a negative view on a specific sector or index, or as a tactical trading tool.

For example, if S&P rises 1%, and unleveraged inverse ETF would fall 1% (ignoring costs and rebalancing).

Traders can choose from a range of inverse ETFs that track different indexes or sectors, such as the S&P 500, the NASDAQ, or a particular industry like technology or energy. It’s important to consider the expense ratio, liquidity, and historical performance of an inverse ETF before investing. While inverse ETFs can be a valuable tool for managing market volatility, they also come with risks (we cover that further down in the article).

Inverse ETF

Leveraged inverse ETFs

You might be tempted to use a leveraged ETF if you have a very profitable strategy. However, don’t fool yourself!

If you experience a heavy drawdown, the losses can be catastrophic, not only for your financial health but also for your mental health. Drawdowns force many traders out of business. Leverage applies to any form of trading instrument – inverse or not.

Understanding market trends for effective inverse ETF trading

Understanding market trends is essential for effective inverse ETF trading. To make informed decisions, you should stay up to date on the latest news and trends in the market, as well as consider various technical analysis tools and indicators. And above all, you should backtest, something this website is all about.

One popular tool for understanding market trends is chart analysis — that is, studying past market performance to identify patterns and make predictions about future market movements. Technical indicators, such as moving averages and relative strength index (RSI), can also provide valuable insights into market trends.

In addition to technical analysis, you should also consider broader economic indicators such as interest rates, inflation, and employment data, as these can greatly impact market trends. However, this needs to be proved and validated via backtesting.

Choosing the right inverse ETF for your strategy

Choosing the right inverse ETF for your strategy requires careful research and consideration of several factors. Here are some important considerations:

  • Underlying index or sector: Consider the index or sector that the inverse ETF is tracking and whether it aligns with your investment goals and market outlook.
  • Expense ratio: Look at the expense ratio of the inverse ETF, as higher fees can eat into your returns. Because of rebalancing, most inverse ETFs have high costs.
  • Liquidity: Ensure that the inverse ETF is highly liquid to minimize trading costs and minimize the risk of slippage.
  • Historical performance: Look at the inverse ETF’s historical performance, including its track record during periods of market decline and volatility.
  • Volatility: Consider the inverse ETF’s volatility, as highly volatile ETFs can be riskier.
  • Correlation: Look at the correlation between the underlying index and the inverse ETF to ensure that the ETF has always moved in the opposite direction of the benchmark as intended.

Diversifying your portfolio with inverse ETFs

Diversifying your portfolio with inverse ETFs can help mitigate risk and potentially enhance returns. When trying to diversify your portfolio, you may want to consider adding inverse ETFs as a complementary strategy to your existing long positions, as this may help balance out your overall portfolio risk. You may also use inverse ETFs to hedge against market risk, particularly if you have high exposure to a specific sector or index.

Whatever the reason, allocate a portion of your portfolio to inverse ETFs as a tactical allocation, using them as a short-term investment tool to capitalize on declining market conditions. Consider diversifying across multiple inverse ETFs, tracking different indexes or sectors. This will minimize the risk of trading a single security.

However, keep in mind that inverse ETFs are not a guarantee of protection against market losses, and the use of these securities can be complex. Therefore, it’s crucial to thoroughly research the inverse ETFs you’re considering, understand their underlying benchmark, and monitor the volatility in the index. It may be necessary to consult with a financial advisor.

Last but not least, you need to find out how inverse they really are. For example, if the underlying index rises or drops 1%, is the inverse ETF 100% inversely related? Most likely it’s not, but by how much?

Timing the market for maximum returns with inverse ETFs

Timing the market is challenging, and inverse ETFs are no exception. However, with careful research and analysis, you can use inverse ETFs to potentially maximize returns in declining market conditions.

One approach to timing the market with inverse ETFs is to monitor key economic indicators, such as interest rates, inflation, and employment data. These may help you identify potential economic turning points, which can also affect the markets. Technical analysis can also provide valuable insights into market trends. You can use moving averages and chart patterns to anticipate downturns in the market.

It’s important to have a well-defined investment strategy and risk management plan in place, as inverse ETFs can be volatile and should be used with caution. In addition, you need to regularly monitor the ETF’s performance and adjust your investment strategy as market conditions change.

The role of risk management in inverse ETF trading

Risk management plays a crucial role in inverse ETF trading.

Due to the nature of inverse ETFs, which aim to generate returns opposite to the underlying index or sector, they can be subject to higher volatility and risk than traditional ETFs. Moreover, the stock market has a tendency to keep rising. You can go belly up on any adverse movement.

Therefore, it’s important to have a well-defined risk management plan in place when using inverse ETFs. This might include setting stop-loss orders, using diversification to minimize risk exposure, and regularly monitoring market conditions and adjusting the investment strategy as needed.

But more importantly, you need to understand the underlying benchmark of the inverse ETF and its historical performance during periods of market decline and volatility. This can provide valuable insights into the potential risk and reward of trading the inverse ETF.

The impact of economic indicators on inverse ETFs

Economic indicators can have a significant impact on inverse ETFs. They provide valuable insights into the economy’s overall health and can signal potential market turning points. Some key economic indicators that can impact inverse ETFs include:

  • Interest rates: Changes in interest rates can impact the value of inverse ETFs. Higher interest rates can lead to decreased economic growth and declining market conditions.
  • Inflation: High levels of inflation can signal a slowing economy, leading to declining market conditions and potentially higher returns for inverse ETFs.
  • Employment data: Employment data, such as the unemployment rate and job growth, can provide valuable insights into the strength of the economy and potential market trends.
  • Gross domestic product (GDP): GDP is a key measure of the health of an economy and can impact the value of inverse ETFs, particularly during periods of economic growth or contraction.

The power of technical analysis in inverse ETF trading

Technical analysis is a powerful tool for inverse ETF trading as it offers traders valuable insights into market trends and helps inform investment decisions. Chart analysis involves analyzing past market trends and patterns to identify potential buying or selling opportunities. Similarly, indicators, such as moving averages and oscillators, provide information about market trends and swings, which can help traders identify potential turning points.

Trendlines help traders determine the market’s overall direction and potential support and resistance levels. Trading volume can offer insights into market sentiment and potential changes in market trends. Above all, it helps to use technical analysis in conjunction with fundamental analysis and market research.

Maximizing profits with inverse ETFs in different market conditions

Maximizing profits with inverse ETFs in different market conditions requires market knowledge, research, and discipline. You need to understand the underlying benchmark of the inverse ETF, including its historical performance during market decline and volatility. This can help you assess potential risks and rewards.

Timing the market correctly is crucial for success with inverse ETF trading. So, you have to keep up to date with market trends so as to always make informed investment decisions. Diversifying your portfolio with multiple inverse ETFs can minimize risk exposure and provide stability during market volatility. But you must also have a well-defined risk management plan, including stop-loss orders and position sizing to protect against losses.

Also, regularly monitoring market conditions, including global events and economic indicators, can help you identify buying or selling opportunities.

Strategies for long-term success with inverse ETF trading

Long-term success with inverse ETF trading requires a well-defined strategy, discipline, and a thorough understanding of the market. Some strategies for achieving long-term success include:

  • Having a well-defined investment plan
  • Diversifying your portfolio
  • Monitoring market trends
  • Implementing a risk management plan
  • Staying disciplined

In conclusion, keep in mind that inverse ETFs do not guarantee protection against market losses. Success with inverse ETF trading requires a combination of market knowledge, research, and discipline. You may have to consult a financial advisor before investing in such risky assets.

Why use inverse ETFs in trading? Pros and advantages

There are a few advantages of using inverse ETFs:

  • You don’t need a margin account to short the market. Most retail accounts have no possibility of shorting (for that, you need a margin account).
  • You don’t need to locate stocks/shares for a short sale (no need to borrow).
  • No stock loan fees (however, that is included in the costs of the inverse ETF fund).
  • You can hedge your portfolio.

Why don’t use inverse ETFs in trading – cons and disadvantages (risks)

Let’s look at the cons and disadvantages:

  • Daily rebalancing (see next headline about an example of how an inverse ETF works).
  • Costs – it costs more to manage an inverse ETF than ordinary ETF.
  • Doesn’t accurately track the market.
  • Traders hold them for too long – they are only meant for trading.

Example of how an inverse ETF works

Let’s make a practical example of how an inverse ETF works (below is a made-up example):

When the price of an index ETF linked to the Nasdaq 100 500 rises by $1, an inverse ETF tied to the Nasdaq 100 would likely decrease by $1. Conversely, if an ETF based on the tech sector experiences a $1 decrease in price, an inverse tech sector ETF would likely increase by $1. This is basics and how it should work in a perfect world.

Unfortunately, in the real world, things are a bit more complex. The actual trading process involves more complexity. Let’s illustrate:

Suppose you invest $100 in a single share of an inverse ETF linked to an index currently valued at 1 000. Since you have acquired an inverse ETF, you anticipate a decrease in the index’s value, increasing your ETF’s value. The next day the market crashes, and the index declines by 10%, closing at 900. Consequently, the value of your inverse ETF increases by 10% to reach $110.

But an inverse ETF needs to rebalance every single day, and calculations recommence the following day.

For instance, if the index opens at 900 and subsequently exhibits a bullish trend, closing at 1 000, this represents an 11.11% increase. Correspondingly, your inverse ETF’s value would decrease by the same percentage. Consequently, your share value declines from $110 to $97.78.

How is this possible? That’s because 11.11% of 110 equals 12.22.

How long should you hold inverse ETFs?

The example above shows clearly that an inverse ETF is not meant for long-term holding and are not meant for long-term investing. If you are considering that, turn around immediately. They are only meant for short-term trading and nothing else. Daily rebalancing means inverse ETFs can be expected to return less than expected.

You must understand the effects of daily rebalancing since every day starts from scratch.

Best inverse ETF trading strategy backtest – does it work?

Let’s make a backtest and example to show you the drag of an inverse ETF when holding it for several days.

In the backtest below, we’ll backtest a strategy that goes both long and short, and we’ll replace the short position with an inverse ETF. How will this affect the performance of the strategy?

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Let’s first backtest the strategy on SPY by trading both the long and short. We get the following equity curve:

Best inverse ETF trading strategy

We started with 100 000 in 1993 and ended up with 6.35 million. Not bad! Perhaps just as good are the relatively small drawdowns that never last long (see the blue curve below).

The following table shows the statistics, returns, and performance of the combined long and short strategy:

Best inverse ETF trading strategy - backtest performance and returns

Finally, let’s look at the annual returns per year:

How long should you hold inverse ETFs?

There is only one losing year! Even the bear markets of 2000-2003, 2008/09, and 2022 were positive.

Replacing a short position with an inverse ETF

Instead of going short SPY, let’s trade the inverse ETF with the ticker code SH. SH trades inversely to S&P 500; we go long SH instead of shorting SPY when we get a short signal. (SH has an expense ratio of 0.89% annually.)

Because SH didn’t start trading until July 2006, we need to make our starting point at that date.

The graph below shows the EXACT same strategy, but one is short SPY (blue line) while the red line is long SH when the short signals trigger. As you can see, the difference is enormous.

Example of how an inverse ETF works

An inverse ETF is not a substitute for short! The short positions (inverse positions) are held for an average of 4.7 days, showing that SH is useless in being an inverse position unless you are day trading.

The chart below shows the equity line of shorting SPY (blue line) while the red line shows the exact same signals, and we take a long position in SH:

Pros and cons of inverse ETFs

The best inverse ETF trading strategy – key takeaways

The most important takeaway from this article is perhaps that there is no best inverse ETF trading strategy, unless you are day trading. Inverse ETFs are best used for day trading, not for holding overnight, because of costs and daily rebalancing. Our backtests showed that an inverse ETF is not a substitute for trading in the inverse direction!

FAQ:

What is Inverse ETF Trading?

Inverse ETF trading involves profiting from declining market conditions by using exchange-traded funds (ETFs) designed to move in the opposite direction of the underlying index. Investors can use this strategy to hedge against market risk, express a negative view on a specific sector, or as a tactical trading tool.

How Does an Inverse ETF Trading Strategy Work?

An inverse ETF trading strategy aims to profit from market declines by buying inverse ETFs. These funds move in the opposite direction of the tracked index or sector. The effectiveness of the strategy depends on factors like the underlying index, expense ratio, liquidity, and historical performance.

What Factors Should I Consider When Choosing an Inverse ETF?

When selecting an inverse ETF, consider factors such as the underlying index or sector, expense ratio, liquidity, historical performance, volatility, correlation with the benchmark, and diversification benefits. These factors play a crucial role in the success of your inverse ETF trading strategy.

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