Inverse ETFs move in the opposite direction of major index ETFs, such as the S&P 500 SPDR (ARCA:SPY) or Dow Jones Industrial Average SPDR (ARCA:DIA). By buying an inverse ETF, you can protect yourself and/or profit from a decline in the major indexes. With the S&P 500 SPDR having already broken through several important support levels, and being in at least a short-term downtrend, it is quite possible the stock markets could see further downside. If that occurs, the following ETFs will appreciate in value, providing hedging and profit potential. Each moves in its own way, though, and some are more volatile than others - which can be both and good and bad, depending on what side of the trade you are on.
The iPath S&P 500 VIX Short-Term Futures (ARCA:VXX) ETN is not an actual inverse ETF. Rather, it is an ETN that measures implied volatility. When the stock market declines, volatility increases and iPath S&P 500 VIX Short-Term Futures ETN moves up. Therefore, even though it is not an inverse ETF exactly, it does move opposite to the indexes, rising as the indexes fall. Currently the ETN is trading at subdued levels - which is common during and just after a uptrend has occurred in the stock market - but if the stock market continues to drop, panic sets in, volatility increases and the ETN will rise rapidly. The 52-week low at $15.57 is support, and can also be used a stop level. If the S&P 500 SPDR drops to $120 from the June 25 close of $131.32, VXX could reach $45, a great potential return based on the June 25 close of $17.14. If the stock market does in fact drop, this trade presents a great risk/reward ratio. There is resistance at $22.88 though, this will need to be broken in order to reach the profit target. On the other hand, if the indexes stabilize, or move higher, the iPath S&P 500 VIX Short-Term Futures ETN is likely to move lower.
ProShares Short S&P 500 (ARCA:SH) ETF moves opposite of the S&P 500, and should therefore do exactly (or close to it) the opposite of the S&P 500 SPDR. Since the indexes began to trend lower starting in April, the ProShares Short S&P 500 ETF has been trending higher. Major support is at $35.37, which is the 52-week low. Unless the indexes reverse course and start trending higher, this level is unlikely to be touched anytime soon, and therefore can be a used as a stop level for long trades. Alternatively, stops can be placed just below the June 16 low at $36.48. With this stop less money is at risk, but there is a higher chance of being prematurely stopped out. The initial profit target for the trade is $42. Along the way, the uptrend must be confirmed by a move through the June 4 high at $39.37.
The Direxion Daily Small Cap Bear 3X Shares (ARCA:TZA) ETF is not for the faint of heart, caution is warranted when trading this ETF. This ETF moves three times the inverse of the Russell 2000 Index. That means if the Russell 2000 drops 1% on a particular day, TZA should increase 3%. With such leverage, profits and losses are magnified. If you are long this ETF and the market rallies aggressively, serious losses could be sustained. Since April though, this ETF has been moving higher. Once again the 52-low at $16.60 presents support and a potential stop area. Alternative stop levels are just below $17.18 and $19. A push above $25 confirms this ETF is still in an uptrend and provides an initial target of $30 to $31.
The ProShares UltraShort QQQ (ARCA:QID) is an ETF that moves twice the inverse of PowerShares QQQ ETF (which represents the Nasdaq 100 Index). The PowerShares QQQ has been very strong in 2012, but recently has fallen off quite aggressively. This in turn means the ProSharesUltraShort QQQ has been rallying quite aggressively. The 52-week low is a ways away now, but is primary support. This can be used as a stop level on long positions, as can $30 and $32. Using the latter two stop levels means less risk, but a higher probability of getting stopped out. The trend is currently higher and is confirmed if the ETF can continue to climb above the June 4 high at $37.59. If that occurs the initial price targets are $42.50, and if that is exceeded, $47.50.
The Bottom Line
Buying an inverse ETF provides a way to either hedge your portfolio against a market decline, or speculate that the major indexes will fall. In either case, when the indexes decline, these ETFs rise and can offset other losses or produce a profit. Each has its own characteristics, though, and should be traded as such. Be especially cautious with the leveraged ETFs, such as the Direxion Daily Small Cap Bear 3X Shares, and ProSharesUltraShort QQQ. Volatile days can produce very large swings, and if unprepared, big losses can result. As with any trade, trading with the trend is usually the favorable strategy. Right now, these inverse ETFs are trending higher, and until something changes (such as a move back below support), up is the path of least resistance.
At the time of writing, Cory Mitchell did not own shares in any of the companies mentioned in this article.