Volatile Market Conditions Could Drive Investors to Trade

Inverse ETFs offer effective opportunity for capturing downward moves

Monday's trading brought volatility back into the markets just at a time when some investors were trying to forget that things like that ever happened. It was a wakeup call for them. With the Dow Jones Industrial Average (DJI) losing more than 1,300 points from the opening trade on Friday to Monday afternoon, some of the more sensitive investors were understandably concerned.

While most analysts would describe this as a natural and short-term pullback, the truth is that no one ever really knows where the market is going next. As it turned out, Tuesday delivered a big bounce back, as investors seemed overly eager to snap up any offered price. This kind of pattern – big drops followed by big pops – can sometimes presage continued market volatility. Since continuing market volatility is more closely correlated with downward trending prices, it makes investors nervous to see it.

The curious investor will naturally want to know what could be done if stocks were to start trending downward more persistently. Many investors are unaware of the exchange-traded funds (ETFs) they can buy that allow them to profit when stock market index prices move lower. These inverse funds are tied to a specific index.

For example, most investors are aware of State Street's S&P 500 index ETF (SPY) or Vanguard’s S&P 500 Index ETF (VOO), both of which track the S&P 500 Index (SPX) with a near perfect correlation. For the Russell 2000 small-cap index, iShares issues an index-tracking ETF (IWM) that correlates positively. ProShares issues ETFs that are negatively correlated to these indexes. That means ProShares' Short S&P 500 ETF (SH) and its Short Russell 2000 ETF (RWM) will increase in value by 1% when the respective indexes they track fall by 1% in value. (See the chart below.)

Comparison of inverse and normal exchange-traded funds (ETFs)

A comparison like the one shown above creates a mirroring price pattern on a chart because these instruments move precisely opposite one another. But the world of ETF issuers didn't stop with these two. They managed to create instruments that are not only inversely correlated but also leveraged.

With inverse and leveraged ETFs, investors could find their positions rising by multiples when stocks drop. That means a double-leveraged (a.k.a. 2X) ETF could rise by 2% for a 1% daily drop in its associated benchmark index, while a triple-leveraged (3X) ETF could rise by 3%.

Direxion's Daily S&P 500 Bear 3X ETF (SPXS) and its Daily Small-Cap Bear 3X ETF (TZA) both provide triple inverse leverage. For anyone lucky enough to hold these on Friday, June 16, to the close of Monday, June 19, the results were quite nice, but only if they managed to close out the trade before Tuesday. Timing can be tricky on these instruments because they are a two-edged sword. Tuesday's reversal in the benchmark indexes meant that leveraged funds fell significantly, as shown in the next chart.

Chart showing Tuesday reversal

For those who can make shorter-term trades and have a good sense for when to take quick profits (or take timely losses), these instruments offer an excellent opportunity to take advantage of volatility in benchmark indexes.

Investors can also take advantage of similar instruments with an even narrower focus, such as a sector index. State Street issues 11 well known sector-specific ETFs. Each of these funds invests in a collection of a dozen or more companies identified within a particular segment of the economy. Each fund is easy to recognize by its three-letter ticker symbol that starts with XL. Currently, the comparative performance of these sector funds shows that those sensitive to inflation pressures are experiencing the largest downward drift. The chart below depicts the way they looked at the end of Monday's trading.

Comparison of sector funds

Looking at this chart, it is not hard to imagine that someone who wanted to take advantage of a downward trend could have searched for sector-specific instruments to help them do so. Considering that the sector funds for finance, basic materials, and energy have been heading lower over the past two months, a trader might have come across Direxion's 3X Finance Sector Inverse ETF (FAZ), ProShares' Short Basic Materials (SBM), or ProShares 2X UltraShort Oil & Gas ETF (DUG), as depicted in the next chart.

Sector Based Inverse ETFs

These funds need to be used carefully. They typically make better short-term trades than long-term investments. However, as markets grow more volatile, they could prove to be a beneficial tactic for a timely trader.

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