With the stock market currently falling, you may be tempted to sell your stocks to take in some gains. But there's another way to protect against loss in your portfolio: short selling.
Shorting a stock can be risky and difficult to accomplish. You have to cover many bases, including getting a margin account, selecting the stock you want to short, and finding another party willing to loan you the equities. It's a lot of work and if you aren't a financial professional, the time you spend could easily add up to the equivalent of a part time job.
There is another way to see the benefits of selling short and it takes less work: Use a short ETF, which essentially does the short selling for you. (For related reading, see: Short Selling Tutorial.)
Short ETFs look to give you the inverse return of the index or category that they are following. Thus, if you believe the market is going to continue to decline, you could purchase an ETF that shorts the S&P 500. If the market goes down by 10%, the short ETF would increase by 10%.
When shorting you can also choose to be short more than one times the index. For example, you can short the S&P 500 by two or three times, thus increasing your gains on the market decline. When searching for these ETFs you will see them labeled as 2x, 3x, or Ultra Short.
Things to Keep in Mind
- Short ETFs can't offer an exact inverse relationship due to fees and daily adjustments to the ETF.
- Fees on some of these ETFs can be high, which eat into your return no matter what the investment. (The list below targets ETFs with an expense ratio of 1.25 or lower.)
- This is not a long term approach to investing. Overall the market typically goes up, so over time this strategy will not be beneficial. Using a short position is best for when you believe things are overvalued and want downside protection without selling out of your long position.
- Short selling is a timing issue. You may believe the market is overvalued and go on to place the trade, but you might be six months ahead of a downturn. You can lose a lot of money in the time before your belief becomes reality.
- These tools can be very illiquid, meaning you may not be able to sell out when you want. Look at the trading volumes to ensure you can get out if you need liquidity.
Here are some ideas for short ETFs in the three asset classes, but remember to use these as starting points to your own research: (For related reading, see: Downtrending Stocks to Short or Sell.)
For sector short selling there are many options. Some include Proshares Short Oil and Gas (DDG), ProShares Ultra Short FTSE China 50 (FXP), Proshares Short Real Estate (REK) and ProShares short Health Care (RXD).
In the debt market you can short bonds just as you would stocks. Some options that accomplish this are Direxion Daily Total Bond Market (SAGG), ProShares Short High Yield (SJB) and ProShares Ultra Short 20+ Year Treasury (TBT).
In the commodities category, the tools to create a short are both ETFs and ETNs. A couple ideas are the United States Short Oil (DNO), DB Gold Short ETN (DGZ) and ProShares Ultra Short Bloomberg Crude Oil (SCO).
The Bottom Line
A great way to protect your returns when the market is overpriced or in correction mode is to deploy short selling. Instead of trying to manage the process on your own with individual stocks, ETFs that specialize in shorting securities is an easier alternative to achieve the results you want. Keep in mind that there are always risks with short selling and that timing is everything. (For related reading, see: Why Is Short Selling Legal? A Brief History.)
At the time of publication, Andrea Travillian was not long any of the securities mentioned. She does not intend to trade those securities within 48 hours of publication.