What Are Inverse ETFs & How Do They Work?

Inverse ETFs are a type of exchange-traded fund designed to profit when the value of an underlying index or asset declines. Unlike traditional ETFs, which move in the same direction as the index they track, inverse ETFs aim to deliver the opposite daily performance of a specific benchmark. For example, if the S&P 500 rises by 1% on a given day, an inverse ETF tracking that index would typically be structured to fall by 1%.

These funds achieve this inverse exposure by using derivatives such as futures contracts, options, and swaps. Inverse ETFs are commonly used by traders looking to profit from a market downturn, or to hedge their portfolio against a potential market decline. They are often employed in bearish market conditions, or as part of a broader risk management strategy. However, similar to leveraged ETFs, inverse ETFs are primarily designed for short-term trading due to the daily rebalancing of their positions.

In addition to traditional inverse ETFs, there are also inverse leveraged ETFs, which seek to amplify the inverse of the daily performance of an underlying index, typically by 2x or 3x. For example, a 2x inverse leveraged ETF would aim to deliver twice the inverse return of the index it tracks, providing a more aggressive strategy for traders expecting a sharp decline in the market. These funds carry higher risk due to the magnification of both gains and losses, and are often utilized for short-term trading, as opposed to a traditional “buy and hold” approach.

Inverse ETFs work by using derivatives, such as futures contracts, options, and swaps, to generate returns that are the opposite of the performance of a specific underlying index or asset. These funds aim to provide the inverse (or opposite) return of the index they track on a daily basis. For example, if the S&P 500 index rises by 1% in a day, an inverse ETF tracking the S&P 500 might be designed to fall by 1%. This approach can make inverse ETFs attractive to traders who anticipate a market decline, and want to profit from that downward movement without having to short-sell the underlying asset directly.

To achieve this inverse exposure, inverse ETFs typically employ complex financial instruments like derivatives. These allow the fund to take a position that benefits when the value of the underlying asset decreases. Inverse ETFs are designed to track the daily performance of the index, so they reset their positions at the end of each trading day to maintain their inverse exposure. That means the inverse return is calculated based on daily changes, and therefore may not reflect the longer-term inverse performance of the index.

While inverse ETFs are effective in offering the opportunity to profit from declining markets in the short term, they require careful monitoring. Since they are reset daily, the performance of an inverse ETF can differ significantly from the underlying index over longer periods, particularly in volatile or sideways markets. Small daily movements, when compounded, can lead to a large difference between the expected return and the actual return, making inverse ETFs more appropriate for short-term trading rather than long-term investment. As such, inverse ETFs (and inverse leveraged ETFs) are often viewed as higher risk investments, and market participants should proceed cautiously when trading in such instruments. 

Inverse ETFs are available in a wide variety of types, each designed to cater to specific market strategies and outlooks. The most common types include standard inverse ETFs, inverse leveraged ETFs, and inverse leveraged ETFs with higher multiples. These funds vary in their level of risk, exposure, and use cases, with each offering unique ways to profit from a declining market.

Additional information on the main types of inverse ETFs is outlined below. 

A double inverse ETF is simply another name for an inverse leveraged ETF that aims to provide twice the inverse return of an underlying index. For example, if the S&P 500 rises by 1%, a double inverse ETF might be designed to fall by 2%. Double inverse ETFs are typically designed for traders looking to amplify their profits in a declining market, but they also come with increased risk due to the leveraged nature of these products. 

Triple inverse ETFs are another name for inverse leveraged ETFs with higher multiples, typically offering three times the inverse return of an underlying index. For example, if the S&P 500 were to increase by 1%, a triple inverse ETF might be designed to decrease by 3%. Triple inverse ETFs are designed for short-term traders looking to maximize profits in a declining market, but they carry significant risk due to the amplified leverage and compounding effects.

While both inverse ETFs and short selling allow investors to profit from a market decline, they work in different ways. Inverse ETFs use derivatives to track the opposite performance of an index, providing an easy way for investors to gain exposure to a decline without directly shorting an asset. These ETFs are designed to deliver the inverse of the daily performance of an index, and they do so without requiring margin accounts or borrowing assets.

Short selling, on the other hand, involves borrowing shares of a stock or asset from a broker and selling them with the intention of buying them back at a lower price. If the price of the asset declines, the short seller can buy back the shares at a lower price, returning them to the broker and pocketing the profit. While short selling may offer better control over a bearish position, it also comes with the risk of unlimited losses. In contrast, inverse ETFs limit potential losses to the initial investment, making them theoretically a less risky alternative for those seeking to profit from bearish market conditions. 

Inverse ETFs offer several benefits, particularly for traders seeking to profit from declining markets, or those looking to hedge existing positions. One of the main advantages is the ability to gain inverse exposure to an index without needing to engage in complex strategies like short selling or margin trading. These funds are accessible, easy to trade, and provide a simple way to bet against the market. Inverse ETFs are also useful for hedging purposes, allowing investors to offset potential losses in their long positions during market downturns. Additionally, because they are exchange-traded, inverse ETFs offer liquidity and flexibility, allowing traders to enter or exit positions quickly and easily. 

On the other hand, inverse ETFs do come with significant risks. Due to their daily rebalancing, these funds are primarily designed for short-term trading, and their performance can deviate substantially from the underlying index over longer periods, especially in volatile or sideways markets. The compounding effect of daily returns can lead to amplified losses, making them potentially unsuitable for investors with a longer-term vision. Furthermore, while inverse ETFs limit potential losses to the initial investment, they still carry risks associated with using derivatives, and the potential for large losses in volatile markets cannot be overlooked. Traders should fully understand these risks and utilize inverse ETFs cautiously with the above considerations in mind. 

• Inverse ETFs aim to profit from market declines by using derivatives to provide the opposite daily performance of an underlying index or asset.

• Inverse ETFs can be used to hedge other positions in the portfolio, or the portfolio as a whole, allowing investors to protect their capital during market downturns. 

• Inverse ETFs offer liquidity and flexibility similar to traditional ETFs, providing traders the ability to quickly enter or exit positions.

• These ETFs can be useful for short duration trades, utilized by investors/traders who anticipate downward market movements, or want to hedge existing positions against potential losses.

• Inverse ETFs provide an alternative to short selling, offering access to downside exposure without the need for margin accounts or borrowing assets. 

• Inverse ETFs are designed for short-term trading, as their daily rebalancing can lead to diverging performance in comparison to the underlying index, especially in volatile markets. Or, over longer periods of time. 

• Inverse ETFs come with amplified risks, including the potential for larger-than-expected losses due to the compounding effect of daily returns, making them less popular with investors/traders trying to express a longer duration market outlook.  

• Inverse leveraged ETFs are designed to amplify inverse returns (e.g. 2x), offering higher potential rewards but with increased risk due to the magnification of both gains and losses.

• Inverse leveraged ETFs with higher multipliers—such as 3x—provide amplified exposure to downside moves, aiming to deliver three times the inverse of a benchmark’s daily return. While this can significantly boost short-term gains if the market moves in the expected direction, it also heightens risk, especially due to the effects of daily compounding in volatile markets.

• A key risk is the potential for substantial losses in volatile markets, where the effects of compounding and daily rebalancing may amplify the negative impact.

• Due diligence and risk management are essential when trading inverse ETFs, as with any investment/trade.