Inverse ETFs – Short Selling

| January 28, 2008 | 0 Comments

When asked how to make money in the markets most brokers reply with the famous Wall Street saying, “Buy low and sell high.”  This is always easier said than done.  Anyone can make money when the markets are moving up and up and up.  But, what if the market starts falling?

As we mentioned in Friday’s article, “Is Your Portfolio Ready for a Recession?”, the 200 day moving average on the S&P 500 turned negative for the first time in years.  So the question is, “Why is this important?”

As an investor, you should be watching this indicator closely.  The indicator simply takes all of the closing prices over the last 200 days and calculates an average.  The next day you add the new closing price and drop off the oldest price.  The result is a smooth line showing the general trend in the market.

The 200 day moving average just started to turn negative?  The last time this happened was October of 2000, a time that the index was trading around 1400.  Just two years later, the market had fallen to around 800, a drop of 42%.

This indicator is watched closely by many professional investors, so it’s not to be dismissed.  Oftentimes, professional investors will see this change in trend and profit by shorting the market.  For individual investors shorting can be difficult to do.

To short stocks, you need to be approved for margin trading by your brokerage firm.  This often requires large amounts of cash and securities in your account.  Some firms also require previous trading experience.  At the very least, you’ll need to fill out a great deal of paperwork.

To short, you need to borrow stock from someone who owns it. Sometimes the stock just isn’t available to borrow.  If you are able to borrow the stock, you immediately sell it in the market.  This short position is what allows you to profit as the price falls.

Shorting stocks is considered risky, as your potential loss is unlimited.  You might even lose more money than you originally invested.  With all of these challenges and risks it’s not surprising that most individual investors don’t short stocks.

So how can we profit from a falling market?

Recently a new type of fund has been established called inverse ETFs.  These funds are designed to move inversely to specific market indexes.  In other words, if the market index moves down, the fund moves up.  These funds also eliminate the risk of losing more than your original investment.  Your total risk is limited to the amount of money you invest.

A number of them are available on different indexes.  One of the largest is the Proshares Short S&P 500 (SH).  It allows you to “short” the entire S&P 500 index by buying a single ETF.  You buy it just like a stock.  By eliminating paperwork, margin issues, some risk, and improving tradability, these funds make shorting the markets easy for the individual investor.

I keep looking at the 200 day moving average turning negative.  It makes me think that now might be a good time to hedge parts of your portfolio with these inverse ETFs.

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Category: Stocks

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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