Since the stock market trends higher or stays level far more often than it declines, it is difficult to make consistent money by shorting stocks or exchange-traded funds (ETFs). Losses on short positions in stocks, ETFs or stock index futures are also potentially unlimited. However, there are times when a bearish bet against a benchmark stock index such as the S&P 500 is appropriate, and there are several methods available.
- Most investors know that owning the S&P 500 index is a good way to diversify your equity holdings since it contains a broad swath of the stock market.
- But sometimes, investors or traders may want to speculate that the stock market will broadly decline and so will want to take a short position.
- A short position in the index can be made in several ways, from selling short an S&P 500 ETF to buying put options on the index, to selling futures.
S&P 500 ETFs
By utilizing the SPDR S&P 500 ETF (NYSEARCA: SPY), investors have a straightforward way to bet on a decline in the S&P 500 Index. An investor engages in a short sale by first borrowing the security from the broker with the intent of later buying it back at a lower price and closing out the trade with a profit. The S&P 500 ETF is huge, liquid and closely tracks its S&P 500 benchmark. Hedge funds, mutual funds and retail investors all engage in shorting the ETF either for hedging or to make a direct bet on a possible decline in the S&P 500 Index.
There are also leveraged short ETFs with the objective of returning twice the inverse return of the S&P 500, but be aware they have much more trouble hitting their benchmark. This slippage or drift occurs based on the effects of compounding, sudden excessive volatility and other factors. The longer these ETFs are held, the larger the discrepancy from their target.
Inverse S&P 500 Mutual Funds
Inverse funds seek investment results that match the inverse performance of the S&P 500 Index after fees and expenses. The Rydex and ProFunds mutual fund families have a long and reputable history of providing returns that closely match their benchmark index, but they only purport to hit their benchmark on a daily basis due to slippage.
Similar to the inverse leveraged ETFs, leveraged mutual funds experience a bigger drift from their benchmark target. This is particularly true when a fund leverages up to three times the inverse return of the S&P 500. The Direxion fund family is one of the few employing this type of leverage.
Inverse mutual funds engage in short sales of securities included in the underlying index and employ derivative instruments including futures and options. A big advantage of the inverse mutual fund compared to directly shorting SPY is lower upfront fees. Many of these funds are no-load and investors can avoid brokerage fees by buying directly from the fund and avoiding mutual fund distributors.
S&P 500 Put Options
Another consideration for making a bearish bet on the S&P 500 is buying a put option on the S&P 500 ETF. An investor could also buy puts directly on the S&P 500 Index itself, but there are disadvantages to this, including liquidity. Staying with the ETF is a better bet based on the depth of its strike prices and maturities. In contrast to shorting, a put option gives the right to sell 100 shares of a security at a specified price by a specified date. That specified price is known as the strike price and the specified date as the expiration date. The put buyer expects the S&P 500 ETF to go down in price, and the put gives the investor the right to "put," or sell, the security to someone else.
In practice, most options are not exercised before expiration and can be closed out at a profit or loss at any time prior to that date. Options are wonderful instruments in many ways. For example, there is a fixed and limited potential loss. Moreover, an option's leverage reduces the amount of capital to tie up in a bearish position. However, remember the Wall Street aphorism that says the favorite strategy of retail options traders is watching their options expire worthless at expiration. One rule of thumb is, if the amount of premium paid for an option loses half its value, it should be sold because, in all likelihood, it will expire worthless.
S&P 500 Index Futures
A futures contract is an agreement to buy or sell a financial instrument, such as the S&P 500 Index, at a designated future date and at a designated price. As with futures in agriculture, metals, oil and other commodities, an investor is required to only put up a fraction of the S&P 500 contract value. The Chicago Mercantile Exchange (CME) calls this "margin," but it is unlike the margin in stock trading. There is huge leverage in an S&P 500 futures contract, and a short position in a market that suddenly starts to ascend can quickly lead to large losses and a request from the exchange to provide more capital to keep the position open. It is a mistake to add money to a losing futures position, and investors should have a stop-loss on every trade.
There are two sizes of S&P 500 futures contracts. The most popular is the smaller contract, known as the "E-mini." It is valued at 50 times the level of the S&P 500 Index. The large contract is valued at 250 times the value of the S&P 500, and volume in the smaller version dwarfs its big brother. Small traders quickly gravitated to the E-mini, but so did hedge funds and other larger speculators, because this contract trades electronically for more hours and with greater liquidity than the large contract. The latter contract still trades on the floor of the CME in the traditional open outcry method. To limit risk, investors can also buy put options on the futures contract rather than shorting it.