Save and Conquer

Most people know that shorting a stock involves borrowing shares of that stock at a particular price, sell them, and then buy shares back at a hopefully lower price to return to the broker. The danger is that if the share price increases, you will eventually have to pay that higher price to get the shares back to return to the broker. Since a stock price can increase continuously, your losses can be unlimited.

On the other hand, when you make a normal purchase of a stock, the worst you can do is lose the total value of the stock if its price goes to zero. You losses are limited. There is a relatively new investment product available called a short ETF. It gives returns like a short, in that it gains value when its underlying stocks lose in value. But unlike shorting a stock, you can only go to zero with a short ETF. How do they work?

To an investor, short ETFs give returns like shorting a stock. If the ETF’s index loses by a certain amount, the ETF’s share price gains by that same amount. The reverse is also true, if the underlying index gains a certain amount, then the share price will go down by roughly that amount.

Internally, the short ETFs use futures and swaps on the shares in their underlying indexes. From an article on thestreet.com,

The index futures are sold, or sold short. The ETF also buys swaps with a negative correlation to the index; this is essentially shorting the swaps.

The swaps exchange the money, depending on the direction of the index. One interesting aspect of this is that the short side of the swap always receives an interest payment for allowing the long side to get the fund’s potential upside. However, if the fund falls in price, the short receives both the downside returns as well as the interest.

In addition, futures are margined instruments which give leverage. The investor only needs to put a little money down for the potential of greater returns. For an ETF returning 100% of the negative return of an index, the ETF needs to put only 10% of its cash into the futures. If the ETF wants to see a 200% negative return, it puts 20% of its money into the futures. The rest of the assets are invested in short-term notes, which pay interest.

This is kind of a mouth full, but what it means is that leverage is used to allow some shorting along with interest-bearing notes to mimic the performance of a shorted stock. They are also not as efficient as regular ETFs for taxes. Some of the capital gain returns from a short ETF that are caused by buying back shorted futures will be taxed as short term capital gains. Also, the interest from the short-term notes will be taxed as regular income.

Keep in mind that a short ETF is a timing vehicle. If you are not comfortable with timing market sectors, then these may not be for you. As I wrote previously, I got stopped out of a leveraged short, which magnifies the shorting of an ETF index by a factor of two, earlier this month. Due to its volatility, I was a bit worried the whole time I owned it. I kept playing with my stop loss order until I was eventually stopped out. Even though I made 10 percent in a short time, I don’t think I will buy the leveraged shorts again.

Stumble it!