Use ETF’s For Long-Short Trading Strategy

| March 24, 2008 | 0 Comments

As an investment banker I regularly met with a number of professional investors.  Each one of these pros had a unique style and focus.  They included hedge funds, mutual funds, vulture funds, money market funds, debt funds, real estate funds.  And even funds of funds!

What always amazes me is one simple fact.  There are more investment funds than there are stocks!

That’s right.  For every stock that’s traded in the markets there’s at least and usually more than one fund.  And, every one of these professional investors has the same goal as you and me.  We’re all trying to make money in the market.

Most of these funds use a tool in their arsenal that the individual investor doesn’t (until now if you’re smart).  These pro investors short the market much more often.

Shorting the market is simple in concept but can be quite complex.  An investor can short a single stock, a particular industry, or even the entire market.  Obviously what they’re trying to do is sell high and then at a later date buy back low.  That’s how they make money in a down market.

So how do they do it?

There are several ways to go short.  You can borrow stock from your broker . . . if you have a big account, are authorized for margin, and your broker wants to lend you the stock.  Another way to short the market is to buy put options.  If you time these options just right the profit potential is huge, but remember all options have an expiration date. Lastly, there are ETFs that are designed to short the market.

Professional investors typically take a short position for one of two reasons.  First is to hedge or protect an investment they already have. The other reason is to capture profits.

There are a group of funds called long-short funds that do this all the time.  These funds take the money they are managing and invest in stocks they think are going up.  Then they borrow money and short stocks they think are going down.

Often these funds dedicate a fixed amount to each position.  Some of the more popular long-short funds are also called 100%/30% funds.  This means they go long with 100% of their capital and then borrow another 30% to go short the market.  The idea is that even in an up market there are stocks that are going down.  If they are right on both directions they can make a great deal of money.

So how can the individual investor do the same thing without borrowing any money?

Up till now it has been difficult for the average investor to manage their portfolio like a long-short fund.  But now there are a number of new products available to do this.  So how do you go short safely?

The easiest way I have found is through short ETFs (sometimes they’re called inverse ETFs).  This new type of ETF is designed to go up in value when the markets go down. Just like a stock, you can buy and sell them all day long.  Now here’s the best part.  Unlike shorting a stock, when you buy a short ETF there’s no risk of a margin call.

Proshares is one of a number of companies that creates short ETFs.  I happen to like them because they have more than 35 different short ETFs.  They’ve classified these short ETFs in four different categories. The largest group is market capitalization ETFs which allows you to short the Nasdaq 100, the Dow, the S&P 500, and a number of the Russell Indexes.  These market cap ETFs are great to use when the entire market is falling.

They also have investment style ETFs which allow you to short stocks based on a particular investment strategy.  These can be used when one strategy is expected to underperform for the next few months.  A third category is the International ETF.  You can short various markets including the Xinhua China market, the Japanese market, and a basket of other emerging markets.

The last way, and my personal favorite, is the sector ETFs.  This is where I see the biggest value to individual investors.  These ETFs give you the ability to go short a particular sector.  You can cherry pick what industries you think might fall in the coming weeks and months and easily profit from it.  Proshares currently has 11 different industries including consumer goods, financial, healthcare, real estate, and technology just to name a few.

These ETFs aren’t for everyone.  However, they can be an exciting way to increase your portfolio returns in a down market.

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Category: ETFs

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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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