Listening to the Inverse ETF Market
One of the beautiful things about quantitative analysis is the way the data – objective, impartial, unequivocal even when it isn’t especially vocal – speaks to us. In the same way that a rapidly darkening sky on an otherwise clear day is often signal enough to leave the playing field, so too can the simplicity of data provide traders and active investors with clues as to what the best next steps may be.
I think of this as the number of stocks earnings our lowest “consider avoiding” ratings of 3 or less out of 10 grows day after day. I think of this as the number of inverse ETFs – exchange-traded funds that decrease in value as markets move higher and become increasingly overbought – earning “consider buying” ratings of 8, 9 or even 10 out of 10 also grows.
With evidence like this, you don’t even have to know how few stocks trading above their 200-day moving averages have pulled back to levels where buyers have tended to find them attractive. The high number of bottom-rated stocks and top-rated inverse ETFs like the Direxion Emerging Markets Bear 3x Shares (NYSE: EDZ) and the Direxion Technology Bear 3x Shares (NYSE: TYP) alone tell us that.
So with these clues that the market in general is overextended, what strategies are most appropriate for short-term traders and active investors normally accustomed to buying weakness and selling strength?
Traders are understandably anxious about selling short into a market that seems determined to plow higher. To this end, rather than selling short any one of a number of stocks that have earned “consider avoiding” ratings, looking to buy inverse leveraged ETFs that have pulled back to extremely oversold levels and begun to earn top ratings is another way to potentially take advantage of markets that may have run too far, too fast, without having to borrow shares to bet against individual stocks.
For example, traders looking to take advantage of overbought conditions in technology may want to consider TYP mentioned above. A more specific look at, for example, overbought conditions in semiconductor stocks may incline a trader to focus in on an inverse ETF like the ProShares UltraShort Semiconductors ETF (NYSE: SSG). Both of these ETFs have sold off enough to trade at levels where traders have been more likely to buy than sell in the short term.
The opportunities for these kinds of trades are limited only by the availability (and liquidity) of the markets involved. Not every market has a liquid and widely-traded inverse ETF, and traders will need to weigh the value of a potential trading opportunity against the ability to get in and out of a position at a reasonable price if a given inverse or inverse leveraged ETF isn’t sufficiently liquid.
That said, adding inverse leveraged ETF trading to your portfolio of trading strategies is an excellent way to ensure that your portfolio gains exposure to as many potentially rewarding trading opportunities as possible. And when ordinary stocks and ETFs won’t do, bringing on the heavy artillery of 2x or 3x ETFs, can be an excellent alternative.
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David Penn is Editor in Chief of TradingMarkets.com