The Difference Between Shorting ETFs and Inverse ETFs (and Which Is More Risky)

For traders looking to profit from a declining market, shorting exchange-traded funds (ETFs) and investing in inverse ETFs are two popular strategies. While both approaches aim to capitalize on downward price movements, there are crucial differences that investors should understand before deciding which one to use.

Shorting ETFs

Shorting an ETF involves borrowing shares from a broker and selling them on the open market with the expectation that the price will fall. The intention is to buy back the shares at a lower price and return them to the broker, pocketing the difference as profit. However, there is a potential for unlimited losses if the share price rises instead of falling.

Pros:

• Allows traders to profit from declining prices in a specific ETF or market segment.

• Provides flexibility in timing and duration of the short position.

Cons:

• Requires paying borrowing fees and interest on the short position.

• Exposes traders to the risk of potentially unlimited losses if the share price rises.

• Involves the risk of being forced to cover the short position prematurely (short squeeze).

Let's take a closer at that short squeeze risk with a fresh real-world example. In early 2021, a group of retail investors on the Reddit forum r/WallStreetBets identified that GameStop's stock was heavily shorted by hedge funds. These investors collectively bought and held shares of GameStop, driving up the price rapidly. As the stock price soared, the hedge funds that had shorted GameStop were forced to buy shares to cover their short positions—basically fueling the price surge in a self-reinforcing feedback loop.

The GameStop saga highlights the potential risks of excessive short selling, as short sellers can face theoretically unlimited losses if a stock price continues to rise. For investors interested in shorting ETFs or stocks, this serves as a cautionary tale about the dangers of overcrowded short positions and the power of coordinated buying pressure from retail investors, which can trigger a brutal short squeeze.

Inverse ETFs

Inverse ETFs are designed to move in the opposite direction of a specific benchmark or index. For example, if the S&P 500 index falls by 1%, an inverse S&P 500 ETF would theoretically rise by 1%. These ETFs use derivatives and leverage to achieve this inverse relationship.

Pros:

• Provides a straightforward way to profit from declining markets without the need for shorting.

• Offers potential for amplified returns due to the use of leverage.

Cons:

• Exposes traders to the risk of compounding losses due to the leveraged nature of these products.

• Typically designed for short-term trading and may not track the underlying index accurately over longer periods.

• Incurs higher fees compared to traditional ETFs.

For a real world example, consider ProShares Short S&P 500 (SH), which provides inverse exposure to the large and mid-cap companies that make up the S&P 500 index. SH is not intended to be held for periods longer than a single trading day. Let's say one day the S&P 500 rose 1.07%. This means shares of SH declined by 1.07%, dropping from $14.88 to $14.72 per share. So, investors who held a position in SH on that particular day—when the broader market rallied—would have incurred losses.

Which one is for you

The decision between shorting ETFs or investing in inverse ETFs depends on various factors, including an investor's risk tolerance, investment horizon, and overall investment strategy.

Shorting ETFs may be more suitable for experienced traders who have a good understanding of the risks involved and can actively manage their positions. It offers greater flexibility but also higher potential for losses.

On the other hand, inverse ETFs can be a more accessible option for traders seeking a more straightforward way to profit from declining markets. However, the leveraged nature of these products and the potential for compounding losses make them riskier, especially for long-term holdings.

Ultimately, both strategies carry significant risks and should be approached with caution and proper risk management practices. It is crucial for investors to thoroughly understand the mechanics, risks, and potential rewards of each approach before making investment decisions. For more, check out whether Bitcoin ETFs have a place in your portfolio.