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  • Nate Carter

Inverse ETFs: Profiting in Bear Markets

Buy and Hold is the Preferred Strategy

I am a buy and hold investor who purchases stocks to hold for years or even decades. I also prefer to diversify my stock holdings by investing in exchange traded funds (ETFs) that replicate the S&P 500 index (symbol SPY) or the Nasdaq 100 (symbol QQQ). Holding these two ETFs provides exposure to a broad range of U.S. companies, including the 500 leading publicly traded companies in the Standard and Poor's index and the 100 largest companies listed on the Nasdaq exchange, many of which are leading tech companies. Holding these indexes will provide exposure to major companies like Apple, Microsoft, Amazon and Tesla.

Investing More When Prices Decline

When the stock market goes into a bear market, as occurred in 2022, it is a great time to invest. For example, QQQ was $401.55 on December 29, 2021, but is now trading at about $283. Similarly the SPY was $477.48 on December 29, 2021, but trades at about $393 today. Both of these ETF shares could have been picked up at even low prices in October this year, allowing investors to already earn a positive return.

ETFs that Profit When the Market Declines

Another investing strategy when markets are in decline is using inverse ETFs. Unlike traditional ETFs that fall in value when the stock market slides, inverse ETFs go up in declining markets. For example, if the S&P 500 falls by 2% for the day, the inverse ETF would climb by 2%. Inverse ETFs provide a hedge against falling stock prices by producing a positive return when stock values decline. These ETFs are sometimes called short ETFs or bear ETFs. They are not a good investment for investors who are highly risk averse or those who won't pay close attention to market volatility in the short term.

Inverse Shares are Not Buy and Hold

Inverse ETFs can cover a wide section of the stock market. The inverse ETF for the S&P 500 is symbol SH and the symbol for an inverse ETF for the Nasdaq 100 is PSQ. Inverse ETFs should only be a small portion of a portfolio and inverse ETFs are definitely not a buy and hold investment.

Inverse ETFs serve as a short term hedge to profit when the stock market is in decline. Investors have to pay close attention to market movements while holding inverse ETFs. When the market declines, selling an inverse ETFs earns a positive return. It can be wise to then reinvest the proceeds in the traditional positive ETF to profit again once markets recover.

Timing the Market is Never Easy

There is an aspect of trying to time the market when it comes to inverse ETFs, so investors should be cautious before they invest. I find inverse ETFs are best when the market has had a robust run up in value, but significant negative news is on the horizon. For example, in January 2020 it was clear that the pandemic would significantly disrupt the global economy and cause stock markets to decline. At that time an inverse ETF position, held for the short term, made sense.

When evaluating inverse ETFs remember that markets can recover suddenly, wiping out the profits of an inverse ETF. Most investors will want to avoid the inverse ETFs called "ultra shorts" as these are weighted 2x or 3x by using leverage. This means returns will double or triple compared to a regular inverse ETF when markets decline. But similarly, if the market turns positive these ETFs will quickly lead to significant losses.

Investing is about understanding the tools that exist to profit in the long term and in the short term. An inverse ETF is not for every investor, but in certain bear markets they can be a tool to increase investing profits.

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