Inverse exchange-traded funds (ETFs) are often used by contrarian traders looking to profit from the decline in value of an asset class, such as an index. These risky investments, often in the form of inverse short ETFs, can be valuable for seasoned market pros. But while these investments can be potentially lucrative, they are definitely not for everyone.

These trading vehicles have become more popular as markets have declined in 2022. The S&P 500 fell into bear market territory in May (20 percent decline from a recent high) and was down about 17 percent as of November, while the Nasdaq was down nearly 30 percent.

Here are some of the most popular inverse ETFs, how traders can use inverse ETFs to short-sell stocks and what traders must keep in mind if they’re thinking of buying a short ETF.

What is an inverse ETF?

An inverse ETF is set up so that its price rises (or falls) when the price of its target asset falls (or rises). This means the ETF performs inversely to the asset it’s tracking. For example, an inverse ETF may be based on the S&P 500 index. The ETF is designed to rise as the index falls in value.

Inverse or short ETFs are created using financial derivatives such as options or futures. They can even be created to move at two or three times the movement of the target asset. Because of how they’re created, though, the value of these ETFs tends to decay over time.

Inverse or leveraged ETFs typically try to track the daily performance of their target asset. So, holding this kind of asset over a long period of time could compound losses. And the higher the leverage of an inverse ETF, the greater the potential decay of value due to their structure.

The ability to trade during market hours makes ETFs an ideal vehicle for financial innovation such as this. That’s one of the key advantages ETFs have over mutual funds.

Top inverse ETFs

The following inverse ETFs are some of the most widely traded, with data as of Nov. 16, 2022.

ProShares UltraPro Short QQQ (SQQQ)

SQQQ offers three times leveraged daily downside exposure to the tech-heavy Nasdaq 100 index. This ETF is designed for traders with a bearish short-term view on large-cap technology names.

Expense ratio: 0.95 percent

Average daily volume: ~143 million shares

Assets under management: ~$3.6 billion

ProShares Short UltraShort S&P500 (SDS)

SDS offers twice leveraged daily downside exposure to the S&P 500 index. This ETF is designed for traders with a bearish short-term view on large-cap U.S. companies across sectors.

Expense ratio: 0.90 percent

Average daily volume: ~9 million shares

Assets under management: ~$809 million

Direxion Daily Semiconductor Bear 3x Shares (SOXS)

SOXS provides three times leveraged daily downside exposure to an index of companies involved in developing and manufacturing semiconductors. This ETF is designed for traders with a bearish short-term outlook on the semiconductor industry.

Expense ratio: 1.01 percent

Average daily volume: ~19 million shares

Assets under management: ~$746 million

Direxion Daily Small Cap Bear 3X Shares (TZA)

TZA provides three times leveraged daily downside exposure to the small-cap Russell 2000 index. This ETF is designed for traders with a bearish short-term outlook on the US economy.

Expense ratio: 1.00 percent

Average daily volume: ~12 million shares

Assets under management: ~$449 million

ProShares UltraShort 20+ Year Treasury (TBT)

TBT offers twice leveraged daily downside exposure to the Barclays Capital U.S. 20+ Year Treasury Index. This ETF is designed for traders who want to make a leveraged bet on rising interest rates.

Expense ratio: 0.89 percent

Average daily volume: ~5 million shares

Assets under management: ~$1 billion

What is short selling?

Short selling is an investment strategy used by traders to speculate on the price decline of an asset. In short selling, traders borrow an asset so they can sell it to other market participants. The objective is to buy back the asset at a lower price, return it to the original lender, and pocket the difference. However, if the asset price increases, traders are on the hook to buy it back at a higher price.

Short selling is a risky strategy because the price of an asset can essentially rise indefinitely. For example, if you buy a company’s stock for $10 and the company declares bankruptcy, your potential loss is $10. However, if you short the same stock, and the company gets acquired, causing the shares to jump to $300, your potential loss is exponentially bigger as you are obligated to buy back the stock and return it to the lender.

The concept of short selling gained notoriety in 2021 when shares of GameStop jumped from around $40 to nearly $400 in a few days as short sellers were forced out of their positions.

What is leveraged short selling?

Leveraged short selling lets traders use debt to increase their buying power. With the additional funds, traders often purchase futures and other financial derivatives to speculate on the stock or bond markets. By taking additional risk, traders seek to capture outsized returns.

Leveraged trading is also known as margin trading. The strategy can be risky because those bets often become outsized losses when a trade goes sour. Plus, traders need to pay back the borrowed funds along with any transaction fees.

Apart from these factors, traders have to pay short-term capital gains taxes, if the assets are in a taxable account. In addition, multiple fees are associated with trading on margin and short selling.

When should you buy an inverse ETF?

Traders have various strategies for using inverse ETFs. For example, some traders use short ETFs to hedge against falling prices in other positions. So, as one position drops, the other rises, capping the potential losses. Other traders may simply use inverse ETFs to make a directional bet on a security or index.

Traders can also use leveraged ETFs, which aim to move two or three times the daily move of the target asset. So, by using leveraged short ETFs, traders aim to magnify investment returns. Think of leveraged ETFs as a fund on steroids.

For example, the ProShares UltraPro Short QQQ ETF (SQQQ) uses swaps and futures to provide three times the inverse daily performance of the Nasdaq 100 index. So, conceptually, if the Nasdaq 100 is down 1 percent, this short ETF could be up 3 percent. It all depends on the type of leverage used and how it connects to the news causing the move.

While that might sound tempting, potential losses can be just as pronounced. Financial derivatives, like other exotic market products, react differently to negative news. Using the hypothetical example above, when the Nasdaq jumps 2 percent, a leveraged short ETF could plunge around 6 percent, depending on the underlying assets used.

Your level of financial knowledge and engagement with your investments are important factors to consider carefully. Even experienced traders often start small and have an exit strategy. The key is to stick to your plan and know when to close out of a losing position.

Inverse ETFs are not for everyone, and regular ETFs can deliver attractive returns for investors without some of the major risks. Here’s how to invest in ETFs.

How to buy inverse or short ETFs

There are plenty of ETF screening tools, including those provided by most brokerage firms. While factors like management fees and daily trading performance are important considerations, you should thoroughly review the fund’s prospectus.

As you narrow your options, the key features to consider are:

  • Leverage: This metric is qualified by a numeral followed by the letter “x.” So, a fund like the Direxion Daily S&P 500 Bull 3X Shares (SPXL) offers three times the performance of the S&P 500 index. If the index goes up, the ETF should go up three times as much. In addition, the leveraged expected return is for a single day, not cumulative over time.
  • Expense ratios and fees: Compared to traditional funds, inverse ETFs carry higher fees. Keep in mind that those costs can add up, so make sure to compare apples to apples and read the fine print.
  • Trading volume: The more liquid a fund is, the easier it will be to buy and sell. Look at how average trading volume compares to similar ETFs.
  • Fund performance: Numbers don’t lie. While doing your research, take a look at a fund’s daily performance. But remember, these funds are not intended as a buy-and-hold strategy.
  • Assets under management (AUM): Many investors use this figure as a vote of confidence to assess other investors’ engagement with a particular ETF. Along with AUM figures, it might be helpful to check the longevity of the fund.
  • Fund issuer: Brands are powerful. And that’s no different in the ETF space. Some investors feel comfortable investing only with large asset managers, while others see the value in newcomers. Decide what works for you and your financial needs.

Use these criteria as a starting point to do more research. For example, some traders find it helpful to study the daily performance of inverse or short ETFs before committing any money.

Bottom line

Inverse ETFs and leveraged ETFs are not for everyone, and really, they’re not even for most investors. They’re better used by more experienced traders who know what they’re investing in and why. Still, investors can use regular ETFs to enjoy solid returns and stick to lower-risk investments that can still drive attractive profits.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.