After all, this could easily just be a bear market rally. And bull markets rarely begin with a bear market rally and head straight higher.

Beware The Bear Market Trap

It makes sense to hedge against a renewed decline. Here’s why smart investors are doing so using inverse ETFs. Read on to find out what they are, how they work, and why you should consider adding one or two to your portfolio in order to protect it…

ETFs: A Safer, More Effective Way To Short The Market

Just a few years ago, investors who wanted to profit from a market/stock downturn had to borrow shares from their broker to short the asset in question. But today, betting against banks, small-cap stocks, or even entire market averages, is just one convenient ticker symbol away.

You can short the market by using an inverse exchange-traded fund (ETF).

And while I’m generally an investor who subscribes to the fact that stocks ultimately rise and produce solid, long-term gains, there are certain times when using inverse ETFs can be very appealing – particularly in the current market environment.

Exchange Traded Funds: A Brief Overview

Before we talk about the hedging advantages of inverse ETFs, let’s quickly review what ETFs are, and how they work…

• Exchange-traded funds are securities that closely resemble index funds, but are more flexible because you can buy and sell them during the day, just like common stocks.
• ETFs give investors a convenient way to purchase a broad basket of securities in a single transaction, offering the convenience of a stock along with the diversification of a mutual fund.
• From a humble start in the early 1990s, the ETF industry has exploded, particularly over the past several years. There are now over 700 ETFs, with $450 billion in assets.

And the advantages? ETFs boast several major ones over mutual funds and common stocks…

• Better diversification
• More flexibility
• Lower costs
• More liquidity
• Tax efficiency

Going Short The Smart Way With Inverse ETFs

Inverse ETFs (or short ETFs) are designed to move in the opposite direction of an underlying index. That means you profit when the benchmark tanks. The lower the underlying asset goes, the higher these funds advance.

Perfect for a bear market like this one.

Think of inverse ETFs as a type of insurance policy for your portfolio. Investing a modest amount in one of them can be a useful way to hedge against market declines, or protect your profits in certain asset classes.

And when an index or stock heads south (as we’ve seen many do with a vengeance recently), an inverse fund can help soften the blow – and in some cases, even generate enormous profits.

For example, on September 30, 2008, four days before the Dow went below 10,000, I sent a special newsflash to my ETF Authority readers identifying 14 securities that could skyrocket as the market heads south.

*Source: Bloomberg. Total returns from 9/30/08 – 3/5/09

As you can see, most of the inverse ETF have done exactly what they were designed to do in this rough market. And it doesn’t stop there…

Double Your Money with Inverse ETFs

Some ETFs can even return double the inverse of the underlying security. For example, if you buy shares of the ProShares UltraShort S&P 500 (NYSE: SDS) and the S&P 500 declines by 5%, SDS gains 10%. (Keep in mind that these funds compound daily, so if you invest for longer, the returns won’t line up exactly).

So how are these ultra-short funds able to double the inverse performance of indexes? Simple… by using leverage. The math doesn’t always work out exactly, but you can usually expect it to return double the inverse within a reasonable range.

The trade-off, however, is that these funds can be incredibly volatile – and if you’re wrong, you lose twice as much. So only consider going ultra-short if you have the stomach for it.

Why You Haven’t Missed Out on Short ETFs…

You may think you’ve missed the boat on short ETFs… but think again.

With the market coming off depressing lows, the current rally may simply be a “dead cat bounce” (which have been known to soar), as the market attempts to form a new bottom.

With this in mind, you may want to consider adding an inverse fund or two to help smooth out some of this unprecedented market volatility.

Good Investing!

Nathan Slaughter

Source: Inverse ETFs: How To Profit From The Bear Market Trap

But it’s not the long-only investors who are making money in this market. “For the first time since 2002 investors who sell short or bet against rising stock prices are basking in some real profits,” says Eric Roseman.

Despite recent gains, this is still as bear market. US stocks are down 20% since their October highs. Two reverse ETFs have been making a killing in this environment, says Eric…

Betting against the market using reverse index funds is a highly-skilled discipline that the majority of hedge funds and investors fail to master. Most investors, even equity long/short hedge fund managers, are typically long-only investors. They’re getting trashed along with everyone else in this lousy market.

Thus far, 2008 has been the first year stocks have declined since 2002. The S&P 500 Index has declined 13% this year while the MSCI World Index has plunged 17%. Worse, developing economies have been ravaged, led by stunning losses in China, Russia and India among many others. The MSCI Emerging Markets Index is down a dizzying 21%.

If you managed to speculate with reverse indexes or exchange traded funds (ETFs) that bet against these and other indexes, then you’re sitting pretty. Even better, some of these reverse ETFs have twice the inverse correlation, meaning that they can boost your returns in a bear market.

For example, the ProSharesUltraShort MSCI EAFE ETF (AMEX:EFU) has surged 45% this year as the benchmark EAFE Index (Europe, Australia and the Far East) has tumbled 21% without leverage. If two times leverage isn’t your game, then the ProShares Short MSCI EAFE ETF (AMEX:EFZ) can still pack a big punch in a bad year for international equities.

The safest and most responsible way to use reverse-index ETFs is to hedge or protect your equity portfolio in a bear market.

But figuring out exactly how much you should allocate to these volatile products can be a tough balancing act. Your answer depends on how much exposure you have in stocks – domestic and foreign – and how much you have invested in fixed-income, commodities, currencies and other assets. Basically, your asset allocation, age, income needs and tolerance for risk will dictate this strategy.

With stocks already down 20% from their October 2007 highs, it might be too late to buy this sort of protection. But then again, if I owned a portfolio of stocks there’s no way I’d leave myself without some sort of downside protection even at these low levels.

This is a bear market and we can still decline another 10% or more.

Source: 2008 Has Been a Great Year for Short-Sellers