Inverse ETFs: Make money in a declining market

A unique feature of ETFs is that they can use leverage and options. This allows them to borrow money and purchase derivatives. By using derivatives, some ETFs are built to move in the direction opposite that of the sector they invest in. These ETFs are called inverse ETFs because they go up when the market goes down – they move in the inverse direction.

For instance, suppose you purchased an inverse ETF on the S&P/TSX 60. You would expect to earn the opposite of what the index earns. If the S&P/TSX 60 fell 10%, then you’d expect your ETF to rise 10%.

Not only does this feature let you make money when others are losing money, it provides a way for you to reduce risk. During periods of uncertainty, inverse ETFs allow you to hedge your stock portfolio. By using inverse ETFs you get many of the same benefits of short selling without the typical risks, margin calls, or costs.

Exchange Traded Funds can also be used to hedge the risk to you during a slide of the U.S. dollar. If the Canadian dollar strengthens or the U.S. dollar weakens, any investment denominated in U.S. dollars, like gold, oil, or any U.S. stock, gets hurt. Buying an ETF that is inverse to the U.S. dollar hedges out this risk for you.

Other ETFs use leverage to magnify gains (and losses) by a factor of 2. When the S&P/TSX 60 goes up 10%, a leveraged ETF that has exposure to the S&P/TSX 60 will go up 20%. There are also leveraged inverse ETFs. What this means is that you would earn a 20% positive return if the S&P/TSX 60 dropped 10%. This makes ETFs truly unique.

Five-star tip: The use of leverage can actually increase your risk if you don’t know exactly what you are doing. You need to fully understand these investments before buying in; better yet, you should consult a professional for help.