Inverse ETFs are designed to profit when markets decline. They provide a way to bet against stocks, hedge your portfolio, or profit from bearish views without the complexity of short selling. In this guide, we will explain how inverse ETFs work, their risks, and how to use them effectively.
What is an Inverse ETF?
An inverse ETF (also called a short ETF or bear ETF) aims to deliver the opposite return of its benchmark index on a daily basis. When the index goes down, the inverse ETF goes up by approximately the same percentage.
Simple concept: If the S&P 500 drops 2% today, a 1x inverse S&P 500 ETF should rise approximately 2%. If the S&P 500 rises 2%, the inverse ETF should fall approximately 2%.
How Inverse ETFs Work
Inverse ETFs achieve their negative exposure through derivatives:
- Swap agreements: Contracts that pay the inverse of an index's return
- Futures contracts: Short positions in index futures
- Put options: Options that increase in value when prices fall
Daily Reset
Like leveraged ETFs, inverse ETFs reset daily to maintain their target exposure. This daily compounding can cause returns to diverge from expectations over longer holding periods.
Daily Return Example
If the Nasdaq-100 index falls 1% today:
- Regular Nasdaq ETF (QQQ): -1%
- 1x Inverse ETF (PSQ): +1%
- 3x Inverse ETF (SQQQ): +3%
If the Nasdaq-100 rises 1% today:
- Regular Nasdaq ETF: +1%
- 1x Inverse ETF: -1%
- 3x Inverse ETF: -3%
Types of Inverse ETFs
1x Inverse ETFs (Unleveraged)
These aim to deliver exactly the opposite daily return of the index:
- SH: Inverse S&P 500
- PSQ: Inverse Nasdaq-100
- DOG: Inverse Dow Jones Industrial Average
- RWM: Inverse Russell 2000
Leveraged Inverse ETFs
These multiply the inverse return by 2x or 3x:
- SDS: 2x inverse S&P 500
- SPXS: 3x inverse S&P 500
- SQQQ: 3x inverse Nasdaq-100
- TZA: 3x inverse Russell 2000
- SOXS: 3x inverse semiconductors
Sector Inverse ETFs
Target specific sectors for bearish bets:
- REK: Inverse real estate
- SJB: Inverse high yield bonds
- ERY: 3x inverse energy
- FAZ: 3x inverse financials
Why Use Inverse ETFs?
1. Portfolio Hedging
The most common use is protecting your portfolio during uncertain times. If you own stocks but expect short-term weakness, an inverse ETF can offset some losses without selling your positions.
Hedging Example
You own $100,000 in stocks and are worried about a pullback before an earnings season:
- Buy $20,000 worth of SH (1x inverse S&P 500)
- If the market drops 5%, your stocks lose $5,000
- But SH gains approximately $1,000 (5% of $20,000)
- Net loss is reduced to about $4,000
This partial hedge reduces your downside while keeping most of your upside potential.
2. Bearish Speculation
If you believe the market or a sector will decline, inverse ETFs let you profit from that view without short selling, which requires a margin account and has unlimited loss potential.
3. Pairs Trading
Some traders go long one sector ETF while going short (via inverse ETF) another sector, betting on relative performance rather than market direction.
4. Avoiding Short Selling Complexity
Inverse ETFs offer advantages over traditional short selling:
- No margin account required
- No borrowing fees
- Maximum loss is limited to your investment
- No risk of short squeezes
- Simple to buy and sell like any stock
Risks of Inverse ETFs
1. Markets Rise Over Time
Historically, stock markets trend upward over the long term. Betting against the market means fighting this long-term trend, which is why inverse ETFs are not suitable for buy-and-hold investing.
2. Compounding Decay
Daily rebalancing causes returns to deviate from expectations over time, especially in volatile markets. Even if an index ends flat over a month, an inverse ETF may lose value.
Compounding Decay Example
Index starts at 100, rises 10%, then falls 10%:
- Day 1: Index goes 100 to 110 (+10%)
- Day 2: Index goes 110 to 99 (-10%)
- Index result: -1%
1x Inverse ETF:
- Day 1: $100 to $90 (-10%)
- Day 2: $90 to $99 (+10%)
- Inverse ETF result: -1%
Both lost 1% even though they move in opposite directions! This is the decay effect of daily rebalancing.
3. Timing Risk
Getting the timing right on market downturns is extremely difficult. Many investors lose money waiting for crashes that do not happen or happen later than expected.
4. Higher Costs
Inverse ETFs have higher expense ratios (0.50% to 1.00%) than regular ETFs due to the cost of maintaining derivative positions.
Critical warning: Inverse ETFs (especially leveraged versions) are designed for SHORT-TERM trading only. Holding them for weeks or months typically results in significant losses due to compounding effects, even if your market view turns out to be correct.
When to Consider Inverse ETFs
Inverse ETFs may make sense when:
- You have a short-term bearish view (days, not months)
- You want to hedge your portfolio before a known event
- You cannot or prefer not to short sell
- You have a specific, time-limited reason to expect a decline
Best Practices for Inverse ETFs
- Keep holding periods short: Days to weeks, not months
- Use stop-losses: Define your exit point before entering
- Size positions conservatively: Do not bet more than you can afford to lose
- Understand the specific index: Know exactly what you are betting against
- Prefer 1x over leveraged: Unless day trading, avoid 2x and 3x inverse ETFs
- Monitor daily: Check positions regularly and be ready to exit
Alternatives to Inverse ETFs
Other ways to profit from market declines:
- Put options: Defined risk, potentially unlimited upside
- Short selling: Borrow and sell shares you do not own
- Reducing exposure: Simply selling some positions
- Cash: Moving to money market funds
- Defensive sectors: Rotating to utilities, staples, healthcare
Monitor Your Hedging Positions
Pro Trader Dashboard helps you track inverse ETF positions alongside your long holdings. See your net exposure and monitor how your hedges are performing in real-time.
Summary
Inverse ETFs provide a simple way to bet against the market or hedge your portfolio without the complexity of short selling. However, they come with significant risks including compounding decay, timing challenges, and the long-term upward trend of markets. Use them only for short-term tactical positions with clear exit strategies. For most investors, reducing exposure or moving to defensive positions is a safer approach than betting against the market with inverse ETFs.
Want to learn more about amplified bets? Read our guide on leveraged ETFs or explore safer approaches in our ETF trading strategies guide.