How do inverse ETFs work?

As far as I know, these inverse ETFs do not roll from one day to the next like a normal stock would. For example, if Index A loses 10% over two months, the inverse of Index A should be up 10%, but it appears from my research into this that it isn’t the case at all.

I think @Oktay can explain better how this works.
I would suggest staying away from things you don’t understand.

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I would also like to understand further how they work.

for example, if a company issues a rights issue and the stock price drops as a result, will the inverse etf rise as a result?

I understand they have fees and such which reduce the price overall, but will the etf rise inverse to the drop, or will they say “because of the rights issue, we’re cancelling the change”

in regards to “I would suggest staying away from things you don’t understand.” I would agree to a point, but people have to learn somehow :slight_smile:

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I’ve done a bit of reading and it looks like:
ETFs appear to only take into account . so if the stock price drops by 90% overnight, that doesn’t matter.
it also looks like they’re pretty dangerous, as a volatile stock price which is constantly going up during open hours, but opens down, then the inverse ETF will only go down.

Highly recommend anyone who is interested, do a good bit of research. as for me - I’m staying away.

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Is the amount you can lose in these inverse ETFs only the amount you invest in them? It won’t draw further cash from available funds if the trade goes horribly wrong. Is this correct?

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Yes, you will never lose more than the money you put in in the Invest or ISA sections.

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Thanks for the tag @Rygel.

@Tradingplc @End-Of-Eternity - the thing to keep in mind about inverse ETFs is that they usually rebalance daily. Simply put, this means that each day is treated as a separate event, so when held for longer periods - the return is not what you expect.

For example, let’s consider an ETF like ‘SPY’ that tracks the S&P 500 index and an inverse fund like ticker ‘SH’ that returns -1x (or inverse) the daily performance of the S&P 500 index.

Essentially, ‘SH’ does the opposite of what ‘SPY’ does. We will assume that they both start at a price of GBP 100.


2 Scenarios to Outline the Difference :warning:


1. Volatile moves.
During volatile moves in SPY, it’s likely that the the inverse product (whether -1x, -2x, or -3x) will underperform compared to what you expect:

You can see that after 1 day: you get what you expect (you made 10%, since ‘SPY’ lost 10%). But by day 3, you have lost over 8% (instead of being at 0% like ‘SPY’).


2. Trending down market.
It’s likely that it will overperform compared to what you expect:

You can see that after 1 day: you get what you expect (you made 10%). But by day 3, you have made over 33% (instead of the expected 27% from the decline in ‘SPY’).


So briefly - for longer periods, short selling will give you the expected returns, while for a single day, the inverse ETF “does its job.” The difference in the inverse ETF is cause by ‘daily compounding.’

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No, they have a price like a normal stock and the lowest that price can drop to is 0 (they can’t deduct from any of your other funds).

Actually found the information you gave pretty interesting, really like that you added the tables makes it much clearer and easier to understand.

Would like to ask though over the longer term do these inverse ETP’s tend to decline in value due to the expense ratio (and the borrowing cost but I don’t know how that works) as I might expect? The volatility also would eat into the inverse returns as it the leverage needs to be reset each day as shown by you in the table (don’t know myself what volatility is needed to start having a big impact on returns).

So why wouldn’t it be viable to short one of these and buy the underlying (ETF or replicate the stocks within the ETF to avoid the expense ratio) to get to a semi-neutral position and thus capturing (part of) the decay? I don’t know how high short interest is in these ETPs (and also don’t know the costs of shorting these things) and I don’t see why this aside from a lack of volatility and high borrowing costs wouldn’t be viable as big firms otherwise would be doing this way before me.

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From the explanation I think it’s better not to keep open the position overnight because of the reset.

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Thanks @Etypsyno.

So let’s break this down into a few parts:

  1. Will the expense ratio eat into profits? Eventually, it will. The performance of the inverse ETF would have to go in the direction that you want AND outperform the expense ratio as well. In general, most of these ETFs have costs that are lower than what it would cost to short the actual underlying product(s) - but this needs to be checked case by case. It also depends on the market - the US was in a 10+ year bull market, so holding any inverse ETFs for longer than a few weeks/months would undoubtedly not have performed well (just see how ‘SQQQ’ performed over the last 10 years vs ‘TQQQ’).

  2. Does the inverse replicate a short position? For the short term - yes. For longer terms, it depends on 3 main factors that essentially worsen its chances of doing what it’s supposed to do:

  • The longer the holding period, the worse it will replicate the expected ‘short position’
  • The higher the leverage factor, the worse it will replicate the expected ‘short position’
  • The more volatile the underlying stock, the worse it will replicate the expected ‘short position’

That said, the compounding effect could work in your favour: In a trending down market in the underlying, the inverse does better than expected. Trending up in the underlying, the inverse ETF does less harm than would be expected (meaning you’d lose less than you actually would shorting the underlying product).

  1. So why wouldn’t it be viable to short one of these and buy the underlying. Do you mean shorting the inverse ETF?
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Again thank you, yes I mean shorting the inverse ETF and also shorting the underlying (which both currently isn’t possible on the platform but hypothetically). I said buying the underlying in my last post that should be selling. The problem I now also see is that in a sustained move in either direction the balance will decrease to favour long or short.

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Hmm… I’m not sure to be honest, but it would be interesting to see. Btw I don’t know if any broker allows short selling an inverse ETF…

What happens when the end of the day comes and you go to sell to rebalance ready for tomorrow if the liquidity isnt there or the spread is huge?

Since ETFs start with initial low assets under management (AUM) and liquidity, the exchange requires them to have a dedicate market maker (DMM) that’s ready to provide bid/ask quotes throughout the day (around 99% of the trading day).

There are exchange maximums for the widest spread that can be charged (the MM can’t breach that). Any major spikes in the spread should be due to unusually high levels of volatility in the underlying stocks, but should not persist if there are no “catastrophic events.”