Reverse Exchange Traded Funds (ETFs) are often used by contrarian traders looking to profit from the decline in value of an asset class, such as an index. These risky investments, often in the form of short reverse ETFs, can be invaluable to seasoned market professionals. But while these investments can be potentially lucrative, they are definitely not for everyone.

Here are some of the more popular reverse ETFs, how traders can use reverse ETFs to sell stocks short, and what traders should keep in mind if they are considering buying an ETF short.

What is a reverse ETF?

A reverse ETF is set up in such a way that its price rises (or falls) when the price of its target asset falls (or rises). Thus, the ETF operates in reverse to the asset it tracks. For example, a reverse ETF can be based on the S&P 500 index. The ETF is designed to rise as the value of the index falls.

Inverse or short ETFs are created using financial derivatives such as options or futures. They can even be created to move at two or three times the movement of the target asset. However, due to the way they are created, the value of these ETFs tends to decline over time.

Inverted or leveraged ETFs typically attempt to track the daily performance of their target asset. Thus, holding this type of asset for a long time could make losses worse. And the higher the leverage of an inverse ETF, the greater the potential degradation in value due to its structure.

The ability to trade during market hours makes ETFs an ideal vehicle for financial innovation like this. This is one of the main advantages of ETFs over mutual funds.

Best Reverse ETFs

The following reverse ETFs are among the most traded, with data as of November 10, 2021.

ProShares UltraPro Short QQQ (SQQQ)

SQQQ offers daily leveraged downside exposure three times the technology-intensive Nasdaq 100 index. This ETF is designed for traders with a short-term bearish view of large-cap tech names.

Fund issuer: ProShares

Expense ratio: 0.95%

Average daily volume: ~ 161 million shares

Assets under management: ~ $ 1.58 billion

ProShares Short UltraShort S & P500 (SDS)

SDS offers daily double-leveraged downside exposure to the S&P 500 Index. This ETF is designed for traders with a short-term bearish view of large-cap US companies in all sectors.

Fund issuer: ProShares

Expense ratio: 0.91%

Average daily volume: ~ 21 million shares

Assets under management: ~ $ 537 million

Direxion Daily Semiconductor Bear 3x Shares (SOXS)

SOXS offers three times the daily leveraged downside exposure to an index of companies involved in semiconductor development and manufacturing. This ETF is designed for traders with a short-term bearish outlook on the semiconductor industry.

Fund issuer: Rafferty Asset Management

Expense ratio: 1.11%

Average daily volume: ~ 12 million shares

Assets under management: ~ $ 191 million

Direxion Daily Small Cap Bear 3X Actions (TZA)

TZA offers three times the daily leveraged downside exposure of the Russell 2000 Small Cap Index. This ETF is designed for traders with a short-term bearish outlook on the US economy.

Fund issuer: Rafferty Asset Management

Spending rate: 1.10%

Average daily volume: ~ 10.7 million shares

Assets under management: ~ $ 474 million

Cash ProShares UltraShort 20+ years (TBT)

TBT offers daily double leveraged downside exposure to the Barclays Capital US 20+ Year Treasury Index. This ETF is designed for traders who wish to make a leveraged bet on rising interest rates.

Fund issuer: ProShares

Expense ratio: 0.92%

Average daily volume: ~ 5.4 million shares

Assets under management: ~ $ 1.5 billion

What is short selling?

Short selling is an investment strategy used by traders to speculate on the falling price of an asset. In short selling, traders borrow an asset so that they can sell it to other market participants. The goal is to buy the asset back at a lower price, return it to the original lender, and pocket the difference. However, if the price of the asset increases, traders are forced to buy it back at a higher price.

Selling short is a risky strategy because the price of an asset can essentially go up indefinitely. For example, if you buy shares in a company for $ 10 and the company declares bankruptcy, your potential loss is $ 10. However, if you sell the same shares short and the company is acquired, which drives the shares to $ 300, your potential loss is exponentially greater because you are forced to buy back the shares and return them to the lender.

The concept of short selling gained notoriety earlier this year when GameStop’s shares rose from around $ 40 to nearly $ 400 in a matter of days as short sellers were forced to leave their positions.

What is leveraged short selling?

Leverage short selling allows traders to use debt to increase their purchasing power. With the additional funds, traders often buy futures and other financial derivatives to speculate in the stock or bond markets. By taking additional risks, traders seek to capture disproportionate returns.

Leverage trading is also known as margin trading. The strategy can be risky as these bets often turn into disproportionate losses when a trade goes awry. In addition, merchants must repay borrowed funds as well as transaction fees.

Apart from these factors, traders must pay short-term capital gains taxes if the assets are in a taxable account. Additionally, there are multiple fees associated with margin trading and short selling.

When to buy a reverse ETF?

Traders have various strategies for using reverse ETFs. For example, some traders use short ETFs to protect against falling prices in other positions. So when one position goes down, the other goes up, capping potential losses. Other traders can simply use reverse ETFs to make a directional bet on a security or index.

Traders can also use leveraged ETFs, which aim to move two or three times the daily movement of the target asset. So, with leveraged short ETFs, traders aim to amplify returns on investment. Think of leveraged ETFs as a fund on steroids.

For example, the ProShares UltraPro Short QQQ ETF (SQQQ) uses swaps and futures to provide three times the inverse daily performance of the Nasdaq 100 index. So, conceptually, if the Nasdaq 100 is down 1%, this short ETF could be up 3%. It all depends on the type of leverage used and how it connects to the news that caused the move.

While it may sound tempting, the potential losses can be just as pronounced. Financial derivatives, like other exotic market products, react differently to negative news. Using the hypothetical example above, when the Nasdaq jumps 2%, a leveraged short ETF could dip around 6%, depending on the underlying assets used.

Your level of financial literacy and your commitment to your investments are important factors to consider carefully. Even experienced traders often start out small and have an exit strategy. The key is to stick to your plan and know when to close a losing position.

Reverse ETFs aren’t for everyone, and regular ETFs can offer attractive returns to investors without some of the major risks. Here’s how to invest in ETFs.

How to buy reverse or short ETFs

There are many ETF filtering tools available, including those provided by most brokerage firms. Although factors such as management fees and daily trading performance are important considerations, you should carefully review the fund’s prospectus.

As you refine your options, the main features to consider are:

• Leverage: This metric is qualified by a number followed by the letter “x”. Thus, a fund like the Direxion Daily S&P 500 Bull 3X Shares (SPXL) offers three times the performance of the S&P 500 index. If the index goes up, the ETF should go up three times more. In addition, the expected return with leverage is for a single day, not cumulative over time.
• Expense and fee ratios: Compared to traditional funds, reverse ETFs incur higher fees. Keep in mind that these costs can add up, so be sure to compare apples to apples and read the fine print.
• Trade volume: The more liquid a fund, the easier it will be to buy and sell. Watch how the average trading volume compares to similar ETFs.
• Fund return: The numbers don’t lie. When doing your research, take a look at the daily performance of a fund. But remember, these funds are not intended as a buy and hold strategy.
• Assets under management (AUM): Many investors use this number as a vote of confidence to gauge the engagement of other investors with a particular ETF. Along with the figures for assets under management, it may be useful to check the longevity of the fund.
• Fund issuer: Brands are powerful. And it’s no different in the ETF space. Some investors feel comfortable investing only with large asset managers, while others see the value of newcomers. Decide what works for you and your financial needs.

Use these criteria as a starting point for doing more research. For example, some traders find it useful to study the daily performance of reverse or short ETFs before committing money.

At the end of the line

Reverse ETFs and leveraged ETFs aren’t for everyone, and in reality they aren’t even for most investors. They are best used by more experienced traders who know what they are investing in and why. Nonetheless, investors can use conventional ETFs to achieve solid returns and stick to low risk investments that can still generate attractive profits.

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Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past performance of investment products is not a guarantee of future price appreciation.