An index exchange-traded fund is typically comprised of most or all of the stocks that make up a particular index, such as the Dow Jones Industrial Average, the S&P 500 or any of the other broad market indices covering different types of companies, industries or sectors. The index on which the ETF is based is known as the target index and the ETF looks to track its performance. That means if the index goes up or down, the value of the index ETF is likely to perform similarly on a percentage basis. In general, these indices, and the index ETFs which track them, tend to be comprised of large-cap stocks.
Some investors actively trade index ETFs in the short-term — with individual trades lasting days or weeks, instead of months or years. Such investors often choose to trade ETFs because they think they are better able to estimate the overall market direction instead of trying to approximate the same for an individual stock, which is more subject to unexpected news events. Of course, the more frequently you trade, the more transaction costs you will incur.
The idea behind shorting an index ETF is pretty straightforward. When running this play, you must expect bearish movement on a wide enough scale to drag down most of an entire index. You seek to capitalize on this bearish activity by borrowing shares of the ETF and selling them on the open market. Then, at a later date you intend to close your short position with buying the ETF shares for less money than for which you sold it, pocketing the difference between the two prices. This is the reverse of the old adage, “Buy low and sell high.” When you are shorting index ETFs you actually want to “sell high and buy low.” The nuts and bolts of going short are covered in the article Short Selling. Regardless of your expectations, the market can always behave counter to what you intend. Shorting an ETF can result in losses if the ETF rises in value. The sharper the increase, the greater the loss will be.
In order to short an index ETF, you must have a margin account. This strategy is quite similar to shorting common stock, but should not be confused with another bearish play, long inverse ETF. As of November 10, 2010, per the SEC, if any stock or ETF has dropped 10% or more from the previous day’s close, short selling will be restricted.
Throughout the life of the trade, you will be required to hold in your account the entire market value of the ETF you shorted, plus additional funds and / or marginable securities to help cover your risk if the trade goes against you. To be clear, not only can you not spend the cash received from the short sale, but if the ETF rises in value, you will need to deposit additional assets to make up the difference. These requirements will be explained further in the section “TradeKing Margin Requirements”.
While the premise behind shorting an index ETF may seem simple, the reality is complex and fraught with risk. For comparison, when you are long an index ETF, you have theoretically unlimited gains and you know in advance exactly how much you stand to lose: namely, your cost basis. You’ve already paid for your potential losses upfront when you bought the ETF. However, when you’re short an ETF, you remain on the hook for cash you’ll need to come up with later, throughout the life of the trade. Here’s the real hitch: when you’re short, your potential gains are limited to the ETF’s price at the time you sold it, whereas your potential losses are theoretically infinite. (Of course, it’s not every day an ETF goes to infinity. Even if it only goes to a gazillion, that would hurt too.)
The best way to deal with these sticky and potentially painful scenarios is to determine in advance just how much you’re willing to add to your cash or marginable securities. That way if you run into trouble, you’ve drawn your proverbial line in the sand and you’ll know to get out before things get worse.
When you’re short an index ETF, you are concerned with two main risks: market risk and dividend risk. Market risk is the obvious one. If the ETF’s price increases, it works to your detriment. The higher it goes, the bigger the hit is to your account. You are also at risk of the fund manager declaring a dividend. This is a fairly common occurrence and should not be ignored. Once the record date for a dividend is established, the "ex-dividend date” ("ex-date") is usually set for two business days prior to the record date. If you are short the index ETF at the market close the business day before the ex-date, you will owe the dividend to the ETF owner.
Although less common, you could face two other risks if there are an overwhelming number of shares held short. First, the ETF may become hard-to-borrow. If this happens, special rules and fees may apply. The other is the possibility of a buy-in. Both of these issues could cause you to exit your position prematurely, either as a result of your own action, or TradeKing’s if necessary.
Shorting index ETFs can be a profitable play if the ETF price is on the decline. Just keep in mind that the risks are more significant than a traditional long index ETF play. Be sure to review the highlighted section on potential risks.
Please note: If you use an index ETF in a market timing strategy, this may involve frequent trading, higher transaction costs, and the possibility of increased capital gains that will generally be taxable to you as ordinary income. Market timing is an inexact science and a complex investment strategy.
Your time horizon may vary according to your investment objectives, skill level, risk tolerance and available capital. Traders may take a short position in an index ETF for very short or long periods, or any time frame in between. This could be a position trade (two weeks to six months), a swing trade (two days to two weeks) or even a day trade. Bear in mind: the more frequently you trade, the more transaction costs you will incur. TradeKing does not promote day trading.
When to Get In
You might consider shorting an index ETF if:
- It’s usually a bad idea to short an index ETF that’s on the rise with the intention of nailing the height of an upswing, because it’s nearly impossible to pick the top. In general when shorting, you want to get in when the ETF is already on the decline.
- There are bearish technical indicators setting up for the index ETF.
- Economic data was released that Wall Street sees as potentially bearish, like low building permits for builders, high crude inventories for oil stocks, low same-store retail sales, etc.
- If you’re trading in the short-term, and the futures market is taking a nosedive, or foreign markets were down sharply overnight, this may indicate possible widespread weakness in the broader market for the opening. Bear in mind: any pre-market jitters may stabilize during the trading session and not continue according to your estimates.
When to Get Out
If you’ve sold an index ETF short, you might close your position based on any of the following:
- There are bullish technical indicators setting up for the index ETF.
- You’ve reached your profit target. Don’t get greedy. Get out before the index has a chance to rebound.
- You’ve hit your figure for how much you’re willing to add to your cash or marginable securities. Get out before the trade spins out of control.
- Your predetermined stop-loss has been triggered.
- There are imminent upcoming events that might generate positive news.
- Before the ex-date if you are short a dividend-paying ETF in order to avoid owing the dividend.
- When short interest in the ETF has increased to a level which may cause the ETF to become hard-to-borrow.
- You’ve given the play adequate time to develop and nothing happens. Stick to the planned timeframe.
Any time you enter a trade, you are obviously expecting the results to be outstanding. But as you know, that will not always be the case. Even the most carefully chosen short position can result in losses if the ETF increases in value.
Just because you’re in the trade doesn’t mean your hard work is over. It’s just begun. If any of the analysis you used to get into your trade shows signs of trouble, take action to reduce or exit your position, if warranted. You’re responsible for knowing the timing of upcoming dividend actions, too .
Whenever you’re short, you need to keep a close eye on the market. Shorting an index ETF is a strategy which requires your attention and discipline. Be prepared to put in significant time managing this trade, and don’t get in unless you can handle the theoretically unlimited risk.
You must keep a short leash on this trade. It can be extremely tempting to stick with a losing trade and hope things will turn around. Don’t give in to such an inclination. Because of this trade’s risk profile, you must be extremely disciplined about sticking to your stop-loss. If your stop-loss is about to be triggered, or you’re nearing your personal margin limit, don’t give the trade more room to go against you. Exit the trade. Don’t rationalize or make excuses; buy back the ETF. If it changes direction and goes on a bearish dive later, don’t beat yourself up. Just stop getting quotes on it and move on to the next trade. Of course it’s important to consider transaction costs when trading, but don’t let them sway you to stay with a losing trade that is no longer in your comfort zone.
Watch out for positive price movement in the ETF. Not only does this pose market risk, it may also change your margin requirements. You may be required to add to your cash or marginable security holdings if there is a margin call. That doesn’t mean you should overstay your welcome if the trade is going too far against you. Don’t ignore your predetermined risk limit.
It may be wise to enter a buy stop order, GTC (good ’til canceled). That can help take away some of the stress of theoretically unlimited risk, and prevent you from acting on emotion and convincing yourself to stay in the trade when logic dictates it’s time to get out. However, please note this will not protect you from gap risk if the ETF opens up sharply overnight or if trading is choppy during the day. Although this is less likely with broad-based indices, gaps can still occur and result in losses in excess of your predetermined amount.
Since some stocks can go up while others go down, an index ETF’s price movement will tend to be less volatile than the average stock. Broad-based indices in particular are less influenced by company news events. However, some indices tend to be more volatile than others. Be sure the index ETF you’re trading is suitable for your risk tolerance. Stand at the ready to manage risk if the index undergoes a period of strong bullish activity. Just because an ETF may have lesser volatility than another investment, it does not mean it is low risk.
TradeKing Margin Requirements
If you understand the risks, shorting an index ETF requires a minimum of 150% of the ETF’s value to remain in your account, consisting of 100% of the ETF’s market value plus 50% of the initial value of the shorted security. The maintenance requirement is usually 140% of the current value. These requirements could increase due to market volatility, fluctuations in the ETF’s value, concentrated positions, trading illiquid or low-priced securities and other factors. Not all ETFs are available for shorting. Margin trading involves risks and is not suitable for all accounts.
If the equity in your account is not sufficient to meet these requirements, you will be required to increase your cash or marginable security holdings to ensure you have sufficient collateral to repay the loan. When this happens, it’s known as a “margin call,” and TradeKing will instruct you to adjust your holdings over the life of the trade.
Investments in exchange-traded funds may impact your tax liability. Read Basic Strategies with ETFs and consult your tax advisor for the low-down on this important topic.