As this past week’s action was getting started, it became apparent that the S&P 500 ETF (SPY) had an initial focus of following through on the prior week’s rebound, to fill the gap up to the 200-hour moving average at 444.50, which is ultimately where the bulls lost their mojo.

Hourly moving averages, specifically the 200-, 30-, and 13-hour moving averages, are key levels I monitor in my daily Total Alpha updates, so to see the SPY subsequently weaken below the 30- and 13-hour moving averages was the early indication that the market was in for a rough week.

The combination of technical weakness, such as I just described, and both economic and political risk, such as the early-week threat of a government shutdown and the ongoing spike in inflationary pressures, is the kind of evidence that should inspire active, nimble traders to consider deviating from their usual bullish postures by acquiring positions that would allow them to benefit from a short-term period of market weakness.

For some of our readers who may still be learning the basics of options trading, and for whom the buying of S&P 500 ETF (SPY) puts or some other bearish options strategy may not be within their comfort zone just yet, there are ETFs that can be purchased which allow traders to profit from downside movement in the S&P 500.

These ETFs are known as inverse ETFs, and today I’m going to walk you through how these ETFs work, the risks associated with them, and how they could have been used to either profit from or help hedge against this week’s selling. 

ETFs, inverse ETFs, and leveraged ETFs. What are they and how do they work?

Before we can get into a discussion about both leveraged and inverse ETFs, it’s important that you at least have a basic understanding of what an ETF is.

ETFs (Exchange-Traded Funds) are open-ended investment funds listed and traded on stock exchanges. 

The term open-ended simply means the fund’s management can issue and redeem shares at any time. 

An ETF’s goal is to replicate, 1-to-1, the performance of an underlying index or basket of assets. 

What are leveraged ETFs?

Leveraged ETFs allow investors to leverage their investment directly without the need to deposit a margin or borrow stocks respectively.

For example, a 1% increase in the performance of an index can result in an approximate 2% (for 2x leveraged ETFs) or 3% (for 3x leveraged ETFs). 

Unfortunately, and this is where many new traders get burned, a downturn in an index’s performance will result in an amplified decline in the returns of the leveraged ETFs.

Now, this next part is very important!

Leveraged ETFs are suitable for investors who have a high conviction in a particular market sector, with a short-term time horizon. We’ll discuss why a little later.

What are inverse ETFs?

Inverse ETFs track the movement of their indices’ performances in the opposite direction. 

In other words, they are designed to have a negative relationship with their benchmark indices. 

Therefore, Inverse ETFs are suitable for investors who are having a bearish view on a market sector and are intending to profit from such a scenario.

Leveraged and inverse ETFs are not designed for investors to buy and hold for the long term. They are meant for active trading purposes.

Many inverse ETFs utilize daily futures contracts and other derivatives to produce their returns. 

There is a negative effect caused by these derivatives, however, in that they require constant rebalancing by the fund manager, which often leads to a deviation from the original investment objectives over time.

These are short-term trading and hedging vehicles that are not meant to be held for more than a day or two.

When to use leveraged and inverse ETFs

A trader with high conviction about a particular market sector or upcoming economic or geopolitical event can buy into these ETFs to gain bearish exposure and earn a higher return than their traditional index-tracking ETFs counterparts.

Investors who are bearish about a market sector can buy into inverse ETFs instead of borrowing securities to short sell, allowing them to avoid the higher costs that come with borrowing shares and obtaining margin during the short-selling process.

A trader would also use these ETFs as hedging tools to protect against losses for an investor’s portfolio holdings, in the event he or she anticipates a short-term, but meaningful pullback in a certain sector.

Here’s how an inverse ETF could have been applied this past week

Listed below are 3 of the most popular inverse S&P 500 ETFs.

First, the ProShares Short S&P 500 (SH) is the most popular inverse ETF, with nearly $3 billion in assets, designed to return -1x the daily return of the S&P 500 Index. For example, a $1 drop in the S&P 500 would cause this ETF to increase by about $1.

If a trader had mild/average that the stock market would start to experience a bearish rotation after struggling to overtake the 200-hour moving average at the start of this past week, this is the instrument that would have been best suited to his or her needs. 

Next, the ProShares UltraShort S&P 500 gives traders looking for a little more volatility a way to add bearish leverage. Specifically, the ETF is a leveraged inverse ETF providing -2x daily returns of the S&P 500. For example, a $1 drop in the S&P 500, would cause this ETF to increase by about $2.

For a trader with higher than average conviction that the stock market would struggle after Monday’s failed to push above the 200-hour moving average, this is the instrument that would have been best suited to his or her needs. 

Lastly, the ProShares UltraPro Short S&P500 gives traders a tool to gain max bearish exposure, with -3x returns. Specifically, the ETF is a leveraged inverse ETF providing -2x daily returns of the S&P 500. For example, a $1 drop in the S&P 500, would cause this ETF to increase by about $3.

Needless to say, this final ETF is the instrument that a trader could have used to short the market earlier this past week if he or she had the extreme conviction that the market would fall.

Tactically, the trading plan would have looked something like this:

1. Identify your outlook
2. Identify your conviction level
3. Identify your target
4. Identify your risk 
5. Identity your timeframe

Let’s face it, in this scenario, we have the benefit of hindsight, right?

But we can still use this past week’s events as an example of how these specialized instruments could have been used, with an emphasis on the time frame aspect of the trade.

For this example, let’s just say that the trader’s conviction level that the S&P 500 would turn lower after Monday’s hesitant start was mild/average.

With numbers 1 and 2 on the trading plan list above now satisfied, the trader would move on to setting a target. 

As Figure 1 shows, the 438.40 was thick with support in the form of the 09/22 – 09/23 gap and post-09/20 anchored VWAP.

Figure 1

When we’re dealing with the short-term holding times that these inverse ETFs demand in order to work optimally, this also would have been an appropriate target zone for an initial decline, given that SPY’s ATR (Average True Range) at Monday’s high was $5. (Monday’s high of 444.00 – 5 (ATR) = 439.00)

Yes, the market did collapse below the initial 438.40 support level during this past Tuesday’s decline; however, at the time this trade was being set up on Monday, there was no way of predicting such a swoon would occur in such a short period of time.

Now that numbers 1 – 3 on the trading plan list have been established, number 4 (risk) needs to be established.

Given that our discussion began with the S&P 500’s early-week struggle to overtake the 200-hour moving average, this average would have been an appropriate stop-out level, preferably on a closing basis.

Interestingly, as Figure 1 also shows, the area where the 200-hour moving average began the week also housed the Anchored VWAP of the S&P 500’s entire decline from its all-time high on 09/02. 

Such a powerful confluence of resistance helps fortify this level as a stop-out level.

Finally, we come to number 5, the timeframe of the trade.

Remember, inverse and leveraged ETFs are constructed in such a manner that they are only to be used for short-term trades. 

Therefore, if the weakness that was anticipated for this trade did not begin to materialize within 48 hours, the trading plan would have called for the inverse ETF position to be closed out.