If you have a feeling that we’re in for in for a market slide, you’re in luck. While others complain about how much money they are losing you could be stuffing your pockets. For most people, investing comes down to buying mutual funds, stocks, ETFs and hoping that they increase in value, and the most common method to fight a declining market is to have money in cash or stocks. Well, there is another way.
Without getting into the mechanics of how selling a stock short works, in the most simple terms it means that you make money when the stock goes down as opposed to going up. This practice carries a number of risks that aren’t associated with typical investing and is an advanced technique that most people don’t use. In fact, this type of trading isn’t even available in most accounts by default, especially retirement accounts.
Introducing Short ETFs
The good news is that you don’t have to be a savvy investor speculating on individual companies in a margin account to make money from declining stocks. There is actually a class of ETFs that work the same as a regular ETF but the difference is that you make money when the underlying index goes down instead of up. There are many different short ETFs available, from broad-based indicies to individual sectors and market cap.
For example, if you had a hankering that the Nasdaq was going to head into a losing streak you could simply buy some Short QQQ (PSQ) and if the Nasdaq does decrease in value, you will actually make money. Or maybe you think the subprime lending mess is going to hit the financial sector really hard, you could profit from banks losing money by picking up some UltraShort Financials (SKF).
A Diversification Strategy
If 100% of your portfolio’s success is determined by how much the stock market increases it might make sense to hedge your bets a little bit with some holdings that go up when things are going down. Obviously this isn’t the type of diversification we’re used to where you diversify with bonds or cash, but it is something worth exploring. I’m not going to get into any specific strategies using these tools, I just wanted to bring it to the surface so people are aware of it.
These types of ETFs are not for everyone and they carry a certain amount of risk just as any other specialized investment does. It takes a new way of thinking to actually consider making money from a declining market. But, if you’re tired of diversifying with bonds you may want to explore other opportunities which could actually increase your returns instead of simply trying to minimize losses.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
I only trade short ETF's on the downside. I hedge against a long portfolio in diverse mutual funds that will ride the market out. That way, I just simply make money during the downturns with a 3x ETF like TZA. You just need to be careful....example...with the markets at their current highs, I have an 80% chance this will plummet 5% in the next month than a 20% chance it rises more than 5%. Especially before an election, fiscal cliff, debt ceiling and bush tax cuts expiring. Stocks look good......but for the short term... they will pull back.
Short ETF's are great but I don't think now is a good time to start looking into shorting the market. The market may slide some more but I think now is a good time to start buying!
This is very interesting. I've never heard of these short ETFs. I hold many ETFs that have declined quite a bit lately. Maybe this is a good alternative to look in to. It's still seems kind of scary because I have no idea how long the market will continue to decline. The way things have been going for me lately, I'll invest in a Short ETF and the market will turn around completely.
My bottom line is this-- under no circumstance is it quantitatively better to long and short a position than it is to move the same amount to cash, so if I believe QQQQ is going down, I'll temper the loss by moving assets to cash, not to PSQ. I'll end up better off that way. That is what I was trying to get at for golbguru.
Right, if you use that formula that is the case, but when you're doing that, you aren't hedging anymore, you are just allocating assets differently. In its pure form, a hedge is an offsetting position of a holding meant to reduce downside risk of that holding.
There is no disagreement that moving toward a high percentage of cash in a down market will be good, and even better than a short hedge in an up market. I think the definition of what was initially suggested as a hedging tool quite a few comments up got lost.
Again, not a long-term strategy, but it is no different than when you buy put options when you are long a stock.
My point is that you will always do better if you take the full OFFSETTING assets (in your example, the 20% short and the 20% long that it offsets, for a total of 40%) and do cash instead of long/short. This is an apples to apples comparison because you are basically eliminating the effect of 40% of your QQQ funds because they offset each other.
In your example, moving 40% to cash instead of 20% to short results in a loss of $300 on QQQ and a gain of $32 on your cash . . . so you lose $268, a better outcome than your short/long scenario. It will always be better to do this, no matter where the market goes, because the two scenarios are identical except the cash earns interest and the long/short tradeoff doesn't. Try it with a market that moves up . . . same situation.
The long/short on the same equities is not smart as a hedge in any situation. You are always better moving the funds that you offset to cash.
Oh, I know what you're saying, but comparing say a 80% long 20% short mix can't be compared to 50/50 mix of stock/cash. Of course that will be better, and in a down market going 100% cash is better, but again, that gets into trying to predict and time the market.
I'm just saying that even though it isn't ideal to hedge with the same asset, it could be better than moving the same percentage of your portfolio to cash.
For example, take a $10,000 portfolio in QQQ. Let's say over the course of 2 months it increases in value 5%. You realize a $500 gain. Just like if the market saw a 5% loss, you'd lose $500.
But if you weren't sure where the market was headed, but wanted to reduce a little risk, so you wanted to move 20% of your assets into something else.
In the first case, you moved 20% into the Short QQQ. Let's say again, the next two months the nasdaq is down 5%. This time, you realize a loss of $300. Then let's assume in the other example you moved that 20% into cash earning 5% APY instead, so over 2 months it earns 0.82%. In this portfolio you would have realized a loss of $383.60, or lost over $80 more.
All things being equal, you fair better in a short-term decline with the short position vs. cash. Of course, the more money you move away from the long position and into either the short holding or cash the better you fair. And in an up market it is a losing strategy altogether, it only serves as downside protection.
Like you said, this is NOT a long-term strategy, and you're right, you never want to mitigate long-term risk with an asset that is expected to decline in the long term against something you expect to increase in value.
The best way to diversify for the long run is with stocks and bonds, two asset classes that over time have proven to always increase, just at different rates with different volatility.
But while the market moves 5%,
-- 50% of your money goes up 5% (long position)
-- 50% of your money goes nowhere (the other 25% in long and the 25% in short cancel each other)
That other 50% would be better served in a MM fund/account no matter where the market goes. At least it's getting that 0.41%, whereas your offsetting ETFs are guaranteed to get 0 or worse (due to ETF expenses).
I'm not saying half cash is a good allocation at all. I'm saying owning an ETF and the ETF that shorts is is a very bad allocation, and is beaten by replacing the offsetting funds with a fixed account. It's never a good idea to hold an asset and its inverse, as you'll only be spinning your wheels.
The bottom line with hedging is you don't want to hedge with something that will effectively NEGATE your gains in other investments. You want to mitigate risk, but both positions better have long-term expected growth. Inverse ETFs have long-term expected losses. That's not a good asset to hold except in the short term if you feel the market is declining (but I don't play that game).
Brad, that's true, but it really depends on the timeframe you're looking at as well as how much the market is moving. Let's say your cash position is earning a typical rate of 5% APY. Well, if the market moves 5% in a matter of weeks, the amount of interest you'll earn on your cash could amount to very little 0.41% per month.
Of course, if we could predict the future, certainly protecting your losses with cash will almost always win out, but if you keep shuffling your portfolio around and moving 50% or more into cash you could hurt yourself just as much if your predictions are wrong and things take back off again. So, by hedging a little bit with a short position (doesn't have to be 75/25, that was just an example) you can remove some of the volatility without relying on timing the market by fussing with your asset allocation.
Jeremy-- If you're going to go 75/25 long/short with ETFs, you'd be better off going 50% long and 50% cash. It puts you at precisely the same risk level and the 50% that was previously offsetting is now gaining a fixed amount.
Golb - As you said, in theory I suppose if the market always went up, at some point it would have to reach 0. But, from a realistic standpoint and how the fund is managed, I don't think that would ever happen. That is way out of my league though.
And like brad said, I'm not sure I'd use them as a direct hedge against other holdings. As he mentioned, if you owned QQQ and hedged it with some Short QQQ, as long as the correlation remained nearly 1:1 you'd just cancel out. Although you could own say 75% QQQ and 25% PSQ, which would ultimately reduce volatility. You wouldn't see the highest gains in an up market and wouldn't see the biggest losses in a down market.
I think the best use of these types of funds is when you want to capitalize during the relative short-term when you see potential markets declining. For instance, if I was heavy in large cap stocks and it looks like small cap might be headed for trouble, rather than adjust my overall portfolio I could just pick up some small cap short etf.
Brad - Thanks for that chart, that is a great illustration of the correlation.
Steve - I'm with you, I don't know very much about these types of alternative investments either, which is one of the reasons I bring it up here so that by discussing them, hopefully everyone can learn something. If I ever get my CFA, maybe I'll understand how these products work.
PSQ hasn't been around that long but so far it has been quite good at inversely mirroring QQQQ. Check this out:
See This Chart
Thanks for elaborating. I guess I'm not studied or interested enough to consider derivative instruments. (Just plain don't understand the how or even why.) Whenever I encounter them in articles or posts, I pose questions such as this one: how do I know it will work (PSQ as inverse performer of QQQ)? Has PSQ been around long enough (trial by fire under several secular market cycles) to say that the managers and analysts and/or programatic formulae of PSQ really know how to make this arrangement of derivatives work as advertised?
I'm not an expert in this, but as far as the hedging benefits of short ETFs go, I would say no-- especially if you intend to hold them long term.
If you hold, for example, QQQQ, and PSQ in an effort to hedge QQQQ, you have effectively found an expensive way to keep cash, as whatever loss you have in one merely offsets your gain in the other. You may as well put the full amount in a high yield account, as you are guaranteed to gain something. Using PSQ to hedge QQQQ is a guaranteed loss after expenses.
I could be understanding you wrong, but when I think "hedge" I tend to think you want to put it in your long-term portfolio to offset risk in other assets. Short ETFs are pointless to hold if you also hold the assets they are designed to short. Use them by themselves in the short-term if you believe that particular index is headed down . . . that's really their only function as I see it. Your position on an index should be fully short or fully long; otherwise whatever amount is in both is effectively cash minus fees.
Jeremy, am I right in understanding that short ETFs are in fact a good way to "hedge" your regular ETFs?
Also, a purely academic question - does the price of a short ETF go opposite to the price of a corresponding normal ETF? If yes, then wouldn't the short ETF go to zero some day if the normal ETF keeps on rising?
That is an excellent question, Steve. To completely understand how they work, you have to realize that the underlying strategy within a short ETF isn't just the opposite of a standard long ETF.
For example, if you buy the QQQ, you are essentially buying a long position of a small amount of each stock in the index. That is very straightforward. But, if you buy the Short QQQ, this doesn't mean the fund is simply selling short the same proportion of the index. If they did that, clearly there would be substantial risk in place for the institution.
Instead, these short ETFs are very complex and may not even sell the individual securities short. For example, from the Short QQQ prospectus:
"Taking positions in financial instruments (including derivatives) that ProShare Advisors believes, in combination, should have similar daily price return characteristics as the inverse of the NASDAQ-100 Index. Short QQQ ProShares will not sell short the equity securities of issuers contained in the NASDAQ-100 Index."
The managers are using derivatives and seeking investments that in combination, should match the inverse of what the QQQ index does. This is why I didn't get into too much detail, because the overall concept of a Short ETF is easy to understand, while the mechanics of how they operate is very different. Their goal is to do the opposite of their benchmark index, yet how that is accomplished may have very little to do with short selling securities at all.
I hit Submit too soon: if buying PSQ does not have the same risk to the buyer as directly short selling QQQ (or its components), where does the risk go? Doesn't someone, or some institution, have to assume it in lieu of you assuming it?
I'd like to understand how shorting an ETF is different from shorting a stock. When one shorts an ETF, does the broker not borrow shares from another owner/account so that one may then sell them, and buy back later so that the broker may return the borrowed shares to the original owner/account?
Being short is one of the most dangerous things you can do so be careful!
Minimum Wage: if you really have knowledge that is accurate, you will eventually be able to find someone to trust you with their money for investing purposes. You could also slowly built up your nest egg that way.
What if you knew stocks were going down (or up) and you have no money? i.e. what good is knowledge without money?
I have some Prudent Bear. (BEARX) However, I'm not actually betting that stocks will go down. A significant portion of my investment portfolio is meant to produce income first, with capital gains as gravy, so a small short position serves to dampen volatility.
Pinyo, that is one of the benefits of shorting via a vehicle like an ETF. Your potential loss is only 100% of what you paid, not unlimited. This is unlike if you were to short an individual stock.
Jade, I think other asset classes outside of stocks and bonds is something everyone should consider. I would encourage a small portion in real estate and commodities in addition to a standard stock/bond mix. With the number of REITs and real estate funds available, and commodity tracking funds/ETFs it is too easy not to explore these investments as well.
It is easier than ever for the average investor to take part in investment opportunities that not too long ago were out of the question or difficult to get into.
Personally, I can't stomach a short position because the possibility of "unlimited loss". However, I do look at short position when I search for value stocks. Always love the boost from short covers. :-)
What do you think about alternative investments for diversification away from the stock market, like the ones NuWire Investor magazine is focused on? Wouldn't it make more sense to diversify out of the stock market completely and into things like real estate and so forth? What do you think about the commodities market, too? Inquiring minds want to know :)
I agree, leverage is great. I'm an options guy myself, so that is typically what I do. But, for the average investor, options are an investment vehicle that is typically out of reach either due to the learning curve or the inability to buy options in their retirement account.
I think if you're going to bet on the market going down, I'd go with buying put options on the ETFS rather than outright shorts, especially if you're overall still long in the market. Mostly just because it's much easier way to leverage.