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Inverse Exchange-Traded Funds versus Shorting Stocks

In bear markets, one of the tools we can benefit from with our covered call writing and put-selling strategies is inverse exchange-traded funds (ETFs). An inverse ETF is also known as a short ETF or a bear ETF. These securities are constructed to return the exact opposite performance of a certain benchmark or index. Many investors consider inverse ETFs the same as short-selling stocks, where shares are borrowed and sold at the current price in expectation of buying them back at lower price thereby generating a credit. We will not focus in on leveraged inverse ETFs because I feel they are not appropriate for most retail investors using these conservative option-selling strategies. This article will explain the mechanism of inverse ETFs and highlight the pros and cons of each investment approach.

 

How do inverse ETFs work?

These securities use derivatives and positions in multiple securities such that the daily gain or loss is the inverse of the traditional index. If the S&P 500 is up 2% in one day, its inverse ETF would be down 2% that same day. Each trading day the inverse ETF rebalances its investments to maintain a constant leverage ratio so the relationship between it and the associated benchmark or index will line up over the short-term but usually not longer time frames.

 

Disconnect between inverse ETFs and shorting results: hypothetical example

  • Index starts at $1000.00
  • After week #1, it drops to $900.00
  • After week #2, it drops to $800.00
  • After week #3, it returns to $1000.00

 

Results from shorting the stock (ETF)

The shares are sold at $1000.00 and bought back at $1000.00, so there no loss or gain outside of fees.

 

Results from using an inverse ETF

  • After week #1, the value of the security is up 10% to $1100.00 (as the index declines by 10%)
  • After week #2, the value of the inverse security is up 11.11% (resulting from the share decline from $900 to $800.00) to $1222.00
  • After week #3, the value of the security is down 25% (resulting from share appreciation from $800.00 to $1000.00) to $916.50

In this hypothetical, the inverse ETF results in a loss of $83.50 compared to the breakeven of short-selling. In the long-term, inverse ETFs tend to under-perform due to daily re-balancing of these securities.

 

Other factors to consider

Both strategies take advantage of declining markets but only inverse ETFs can be used in conjunction with our option-selling strategies. On the negative side, inverse ETFs come with expense ratios averaging 1%.

Short-selling will better match dollar-for-dollar the longer-term movement of the index or benchmark but short-sellers would be responsible for payment of stock dividends in certain circumstances and may be susceptible to margin call. Here is a chart summarizing the pros and cons of each strategy:

 

bear market strategies

Inverse ETFs versus Short-Selling

Some might add that another advantage of inverse ETFs is that the maximum loss is limited to the cost of the shares whereas there is unlimited loss potential with shorting because share price can theoretically move to infinity. This assumes that there is no exit strategy opportunities executed and that simply does not apply to The Blue Collar Investor community.

 

Discussion

Inverse ETFs have a place in our short-term option-selling strategies. They are appropriate in confirmed bear markets (2008 was a perfect year for these securities) where we can sell out-of-the-money calls and puts to generate income. It is instructive to understand that short-selling is not the same as buying inverse ETFs.

 

New webinar available to premium and video members later this month

Covered Call Writing with Buy-And-Hold Stocks

Real-life examples in a bear market environment

I created a real-life $100k portfolio to demonstrate actual transactions in my brokerage account demonstrating how to trade in a bear-market environment using Dow 30 stocks in a long-term buy-and-hold portfolio. Charts were created for the underlyings to graphically better understand the timing of these trades. 

Also, Ask Alan video # 145 will be added to the library of these videos this week. The screenshot below shows the locations of all Blue Hour webinars and Ask Alan videos:

Alan Ellman videos

Premium web page

Upcoming events

1- The Association for Technical Analysis (AFTA): Dallas Texas

April 17 @ 6:30 pm9:00 pm
Crowne Plaza Hotel

“How to Generate Monthly Cash Flow and Buy a Stock at a Discount Using Two Low-Risk Options Strategies”

Tuesday April 17, 2018 6:30 PM – 9 PM 

Crowne Plaza 14315 Midway Rd Addison, TX 75001-3505   

Click here for club website

 

2- Long Island Stock Trader’s Investment Group

Tuesday May 8th, 2018 7PM -9 PM

Using Stock Options to Enhance Portfolio Returns

 

3- Las Vegas Money Show

May 14th @ 11 AM – 12 PM

All Stars of Options

 

Market tone

This week’s economic news of importance:

  • Markit manufacturing PMI March 55.6 (expansion)
  • ISM manufacturing index March 59.3% (60% expected)
  • Construction spending February 0.1% (0.4% expected)
  • ADP employment March 241,000 (last 246,000)
  • Markit services PMI March 54.0 (54.1 last)
  • ISM non-manufacturing index March 58.8% (59% expected)
  • Weekly jobless claims 3/31 242,000 (225,000 expected)
  • Trade deficit February (-) 57.6 billion (57.4 billion expected)
  • Non-farm payrolls March 103,000 (170,000 expected)
  • Unemployment rate March 4.1% (4.0% expected)
  • Average hourly earnings March 0.3% (expected)

THE WEEK AHEAD

Mon April 9th

  • None scheduled

Tue April 10th

  • Producer price index March
  • Wholesale inventories February

Wed April 11th

  • Consumer price index March
  • Core CPI March
  • Federal budget March
  • FOMC minutes

Thu April 12th

  • Weekly jobless claims through 4/7

Fri April 13th

  • Job openings February
  • Consumer sentiment index

For the week, the S&P 500 fell by 1.38% for a year-to-date return of (-) 2.59%%

Summary

IBD: Market in correction

GMI: 1/6- Sell signal since market close of March 23, 2018

BCI: Selling all in-the-money strikes for all new positions. Currently fully invested and rolling down to out-of-the-money strikes (as they relate to current market value) when opportunities arise. Will re-adjust when the market settles.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a bearish sentiment. In the past six months, the S&P 500 was up 2% while the VIX (21.41) moved up by 125%. Historically, the VIX and S&P 500 are inversely related.

Wishing you much success,

Alan and the BCI team

 

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

19 Responses to “Inverse Exchange-Traded Funds versus Shorting Stocks”

  1. Barry B April 7, 2018 11:57 pm #

    Premium Members,

    This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 04/06/18.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:

    http://www.youtube.com/user/BlueCollarInvestor

    Best,

    Barry and The Blue Collar Investor Team

    barry@thebluecollarinvestor.com

  2. Bob April 8, 2018 5:09 am #

    Hi : Alan,

    First and Foremost my “Thanks to You” for all your advice/suggestions on how to Trade Selling Options

    My Question — In a recent E-mail you suggest………..
    a buy back in the 1st half @ 20% and a buy back in the 2nd half @10%

    Do you mean Take Profits when we hit 80% of the Maximum Premium in the 1st half of the contract and Take Profits when we hit 90% of the Maximum Premium in the 2nd half of the contract

    Many Thanks

    Keep Smiling

    Bob

    • Alan Ellman April 8, 2018 12:20 pm #

      Bob,

      The 20%/10% guidelines are in place to mitigate losses or turn losses in gains. In some cases, we can also use these guidelines to create a second income stream (“hitting a double”).

      When using our exit strategy arsenal, we must first close the short call position to avoid risky naked option positions. By employing the 20%/10% guidelines, we are ensuring retention of 80 – 90% of the original premium generated.

      We have other strategies when share price rises (MCU, rolling out etc.).

      Alan

  3. Keith April 8, 2018 8:06 am #

    Alan,

    When is the best time to roll out or out and up if a stock price moves higher than the option strike price and we don’t want to sell our shares?

    Thanks,
    Keith

  4. Marsha April 8, 2018 9:48 am #

    Alan,

    How do we decide how far out of the money we should go with our strike prices when we don’t want to lose our shares?

    Thanks as always,
    Marsha

    • Alan Ellman April 9, 2018 7:56 am #

      Marsha,

      First, we must set an annualized goal. From there, we can select out-of-the-money strike prices that are appropriate for these goals. In the screenshot below of the (soon-to-be-released) BCI Portfolio Overwriting Calculator, 3 strikes are listed for American Express (AXP) when the shares were priced at $91.68:

      If our annualized goal was to generate an additional 6% per year, we would target the $93.50 strike (red oval).

      If our annualized goal was to generate an additional 8% per year, we would target the $93.00 strike (blue arrow).

      If our annualized goal was to generate an additional 5% per year, we would target the $94.00 strike (purple arrow).

      CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG

      Alan

  5. Barry B April 8, 2018 7:59 pm #

    Premium Members,

    There was a typo in this week’s Premium Member Stock Report. The GMI: 1/6- Buy signal since market close of March 23, 2018

    This should be SELL signal.

    Thank you Tom…

    Best,

    Barry

  6. Marty April 10, 2018 4:33 am #

    Alan,

    I have a question about changes in dividends. If a company raises its dividend, how does that effect the value of options if at all?

    Thank you,
    Marty

    • Alan Ellman April 10, 2018 8:01 am #

      Marty,

      When a dividend increases, the puts expiring after the ex-dividend date will rise in value, whereas the calls will decline by a similar amount.

      BTW: Changes in interest rates will have the opposite effects…increase call values and decrease put values.

      Alan`

  7. MarioG April 10, 2018 5:46 am #

    Interesting day today: Week 4 / 5 Expiration 4/20

    Yesterday 4/9/18, I rolled down two securities, AMAT and KWEB which were now Long positions. Both were more than 3% up so the STO premium were very favorable just 10 trading days before expiration.

    This is how I analyzed the AMAT trade.

    AMAT:
    Last price 54.1, BE 55.84, Return cost basis 57.7 Current loss 3.01% ((54.1-55.84)/57.7)

    April 20 Strike 55 premium was 1.2 (Bid/Ask 1.20/1.21) which is 2.1% income (1.2/57.5) or $120 per 100 shares and a net loss of 0.91% at the current price of 54.28. The new BE would be 54.64. If the stock gets assigned at 55, the next gain in the position would be 0.6% ((55-54.64)/57.7).

    Ideally, I would AMAT to trade below 55 at Expiration so I can unwind the long position at a peak during the next cycle before the earnings date of 5/17/18, 1 day before Expiration Friday. Also, might be a good idea to trade weeklies to get some additional income before then.

    I noticed because of the decline of the market near closing today, the premium for strike 55 is now $0.77. Will monitor it for a 10% rule threshold.

    Mario

    • Roni April 10, 2018 1:36 pm #

      Mario,

      well done.

      I did roll down too yesterday noon my last 2 uncovered positions (NVDA and ATVI) to mitigate losses from the correction.

      Roni

      • Jay April 10, 2018 2:08 pm #

        Hey Mario and Roni,

        Thanks for the updates and I look forward to hearing how the April expiry ends up treating you. The both of you are so on top of this stuff I bet you will beat SPY for the expiry!

        I sold a bunch of ATM cc’s for April and bought back but did not roll down when I likely should have since I want to keep the shares and the initial premium was good enough.

        This seems a news driven market and since it has been mostly bad I did not want to block upside if sentiment turns.

        This is probably simplistic and cynical of me but I think Trump’s ego is too big to allow a significant market sell off without Tweeting something to change it since he prided himself so much on last year’s gains :)! – Jay

        • roni April 10, 2018 5:43 pm #

          Hello Jay,

          today it looks like you made the best choices.

          I did roll down 8 of my 9 positions gradually after the correction and did it on the days and the time when the market was up and favorable.
          It will mitigate my losses, but I do not believe that there will be any gain in my total market value on 04/20. We must wait and see.

          In hindsight, I would be better off today if I had waited, but, as they say, “hindsight is the best sight”, and I am sure that I did the right trades at the time I did them, and I feel very good about it.

          Take care – Roni

          • Jay April 10, 2018 6:50 pm
            #

            Thanks Roni,

            You made great trades everyone here can learn from. We can only live and trade in the moment. Hind sight is fun but if it was worth anything we would all be driving our cars backwards using the rear view mirror :)!

            Come April expiry look at your account value change versus what holding SPY did during the period. That’s an honest benchmark for me on whether all the trading is worth it or not. -Jay

        • Roni April 11, 2018 3:13 pm #

          OK Jay,

          I will do that.

          Best…..

  8. Dave April 10, 2018 1:25 pm #

    Good morning Alan,

    Can you please define again what are banned stocks? and why wouldn’t we consider those for the stock selection at all? or you can direct me to the sources. I googled to find more the explanation but so far I haven’t found any good source yet.

    Thank you.

    Dave

    • Alan Ellman April 11, 2018 7:42 am #

      Dave,

      The “banned stocks” are those that fall into 2 categories:

      1. Report same store retail sales on a monthly, rather than a quarterly, basis.

      2. Airline stocks that report monthly “capacity reports”

      These reports represent similar risk as do earnings reports so it is best to avoid them.

      See pages 203 – 204 of “The Complete Encyclopedia for Covered call Writing- Volume 2” for more information.

      Alan

  9. Jay April 11, 2018 2:12 pm #

    Hi Friends,

    I am never sure where to place posts after the Ask Alan monthly video comes out so people see them? But I will stick with the open blog conversation. Today’s was a good one and, Kevin, I agree with Alan and would have done nothing different than you did. Stocks will be stocks and sometimes the rug gets pulled out for no reason! You did a hell of a lot better than straight GRUB holders did.

    If anyone here is like me you may have a large cash position being somewhat skittish new buys recently and/or may have cash coming open at expiry. A conservative way I am looking at using cash at the “risk”of upside lost stock opportunity is with CSP’s for May on SPY and QQQ. With VIX at 20 the premium on those two high liquidity ETF’s is better than last year.

    With SPY at 264.7 and it’s 200 day support at 259.7 you can go almost 5 points below that to the 255 May monthly and sell it for 1% monthly return. That’s not bad: 1% monthly return with 3.6% loss protection selling under a support line that has held 3 times recently. It won’t make you rich, you need to want more SPY in your portfolio but it sure beats letting the cash just sit there!

    Same idea with QQQ. It’s at 161 pushing it’s 100 day MA resistance from below. It’s 200 day support is down at 153.42. It is more volatile and has higher premium. You can sell a CSP under the 200 day support at 150 and still get over 1% for the month with 6.8% loss protection.

    So food for thought for what it is worth….- Jay

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