Inverse ETFs: make money in declining markets

Is it possible to make money in falling markets? Yes! This question would elicit laughs from traders with financial market experience. They have various strategies to win when the markets are down. For those who are new to trading, the topic is interesting. That's why we're gonna talk about inverse exchange-traded funds (ETFs). Financial instruments that allow you to achieve a certain level of profitability by investing in declining markets or assets.

It's true that trying to profit from a market, a company or a set of financial assets that is not doing well is  risky. Traders who choose this route should be aware that this type of game has a significant number of possibilities for failure. Therefore, inverse ETFs, short selling and other similar strategies should be treated with caution.

Inverse ETFs are funds that bet on bear markets. Most of the underlyings of these exchange-traded funds are derivative instruments in which the fund takes a short position or seeks to drive the asset down.

We will discuss the pros and cons of these ETFs and the risks of which you must be aware.

What is a reverse ETF?
An inverse ETF is an exchange-traded fund. Unlike other ETFs that we have had the opportunity to analyse, so-called inverse ETFs are focused on the decline of markets, indices and other underlying assets.

Otherwise, an inverse ETF has all the characteristics of other exchange-traded funds. These are group investments. ETF shares can be bought and sold on the secondary equity market. They have an administration which, depending on the type of ETF, can be active or passive.

However, there are no markets, indices or financial assets that are always down. This would go against all market logic. The question is therefore how the investments of an inverse ETF are made. These types of exchange-traded funds use financial derivatives to profit from falling markets.

Most of their assets consist of futures contracts. This allows fund managers to speculate on which markets and indices will go down. Just take a short position on a future.

Of course, managers open and close positions in the futures markets all the time. So we already have the idea that it is a very active management. Investing in an inverse ETF may result in higher costs and fees for the investor.

You can imagine that investments in inverse ETFs are short-term. The dynamic of opening and closing positions through financial derivatives is the reverse of a long-term position.

How is this different from short selling?
At the beginning of this article, we argued that investors have various strategies to take advantage of bear markets. Inverse ETFs and short selling have one thing in common. These are strategies for winning when the market goes down. But these are different instruments and different ways of trading.

Traders who practice short selling must have a margin account provided by their broker.

Thanks to the margin account, the investor borrows money from his broker. With this money, he buys certain assets such as stocks or currencies. He then sells them on the market. The third step is to buy back those assets when they have fallen.

At that point, the investor repays what he borrowed. Short sales are high risk transactions and require a high degree of market knowledge. Margin accounts, on the other hand, involve high interest on loans received by the investor.

What are the most common derivative products used by inverse ETF managers? Three derivative instruments stand out in this area. All offer high risk exposure in trading:
Futures contracts
Options
Swaps

Derivatives are considered aggressive investments. In each contract, there are two positions. A long, the buy side, and a short, the sell side. In an attempt to earn a return on declining assets, managers of inverse ETFs will seek to take a short position.