Inverse Exchange-Traded Funds (ETFs) use derivatives to bet against the direction of financial markets. These are known as short or bear ETFs and will make money if markets decline in value. They will lose money, however, if markets move against the bet. Covered call writers who have a bearish market outlook may find these funds useful. Inverse ETFs will UNDERPERFORM in normal market conditions. In extreme bear market environments, covered call writers and put-sellers may want to utilize these securities to generate income from both option sales and security appreciation.
Popular Inverse ETFs with adequate option liquidity (associated benchmark)
- PSQ: Short QQQ (Nasdaq-100)
- DOG: Short Dow 30 (DJIA)
- SH: Short S&P 500 (S&P 500)
- RWM: Short Russell 2000 (Russell 2000)
S&P 500 comparison chart (as of 1/20/2016)
Note that the inverse ETFs have appreciated in value over the past three months while the S&P 500 has declined by 8.5%.
Covered call writing example: Options chain for SH (Short the S&P 500)
Using the Basic Ellman Calculator, we see that initial 1-month returns calculate to 2.2% with a possibility of an additional 0.6% if share price moves to the $23.00 strike. This would result in a potential 2.8%, 1-month return. As always, we must be prepared with our exit strategies if a trade turns against us.
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As we enter another earnings season, exchange-traded funds (including inverse ETFs) offer the advantage of not managing earnings reports since ETFs are baskets of stocks with some having positive and others negative results.
Inverse ETFs are securities available to us when selling options. They are most appropriate in extreme bear market environments as they will allow us to generate both option profit and share appreciate as markets decline. We must be prepared with our exit strategy arsenal and have the flexibility to change to more conventional securities when markets turn positive. Historically, markets go up.
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Global markets rebounded towards the end of the week as comments from European Central Bank President Mario Draghi suggested further action to boost inflation toward the ECB’s target rate. Comments from Chinese and Japanese policymakers also hinted at further action. Market volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX) declined to 23.5 after a spike above 32 earlier in the week. Crude oil prices were also elevated slightly at the end of the week. This week’s reports:
- Oil recovered late in the week on hopes of additional monetary and fiscal stimulus from Europe, Japan and China and less aggressive Fed tightening
- New applications for unemployment benefits rose to 293,000 in the week ending January 16th
- The US Consumer Price Index fell 0.1% in December
- For all of 2015, prices rose 0.7%, according to the US Department of Labor
- Sluggish inflation measures call into question the need for additional Fed rate hikes.
For the week, the S&P 500 rose by 1.41% for a year-to-date return of – 6.70%.
IBD: Market in correction
GMI: 0/6- Sell signal since market close of December 10, 2015
BCI: 1/3 of my stock investment portfolio remains in cash short-term. Favoring only deep out-of-the-money puts and in-the-money calls on active positions. Although an up week is welcome news, one week does not confirm a bottom so caution remains a focus in my current investment portfolio. With earnings season heating up, I expect a more positive market short-term. Plan to get more aggressive when markets calm.