How Do Inverse ETFs work?

An inverse ETF aims to return the opposite of a specified index or benchmark for a specified period of time (usually one day). Let’s say you think the market is overdue for a sell-off and are concerned about your existing portfolio. You purchase inverse ETF ‘A’ which is a single inverse ETF that tracks a theoretical Market index. Remember, inverse ETF A delivers the opposite return of the ‘Market’ index per day. If the ‘Market’ index goes down 2% on Monday, then inverse ETF should go up 2% on Monday. Then the process begins again on Tuesday, starting from these new values. Maybe you’re still left wondering, how do inverse ETFs work? Here’s an example.

A Simplified Inverse ETF Example

Say the market Index level is 100. Assume inverse ETF A price is $50. On Monday, the market goes down 2%. The market index level then becomes 98 (original level minus the 2% loss or 100 x 0.98 = 98).  Since the market went down 2%, inverse ETF ‘A’ goes up 2% on Monday. Inverse ETF A’s price then becomes $51 (original price of $50 plus the 2% gain or $50 x 1.02 = $51). Then the process begins all over again for Tuesday from these new starting values (market index of 98 and inverse ETF ‘A’ price of $51).

Unlike traditional ETFs which track a benchmark holding a basket of underlying securities or some other replication strategy, inverse ETFs have no actual assets. Their holdings are derivatives. It is through the use of these derivatives (often swaps, options and futures) that inverse ETFs may deliver the opposite return of their specific index or benchmark.

The derivatives are contracts, or legal agreements, typically between two parties (the issuer of the inverse ETF and a counterparty, or several different counterparties). The counterparty is often a major financial institution who is obligated to deliver based upon specifications of the agreements. Occasionally, the counterparty may be simply a trading desk in the issuers own firm.

How Do Inverse ETFs Work?

Take an example of a hypothetical swap agreement based on the inverse ETF ‘A’ example above. Inverse ETF ‘A’  aims to deliver the opposite return of the ‘Market’ Index on a daily basis.  To accomplish this, inverse ETF ‘A’ enters into a swap agreement with counterparty ‘B’. Counterparty ‘B’ agrees to pay (or receive) the opposite return of the index (in our example its the hypothetical “Market Index’) per day. If the Market Index goes down 2% on Monday, the ETF ‘A’ would go up by 2% and the return would come from the counterparty paying that amount to the inverse ETF, per the agreement. Had the Market index gone up, the inverse ETF would have lost value and the inverse ETF would have been obligated to pay the counterparty the return. If full payment isn’t made, the two parties in a derivative transaction are required to at least post margin and deposit some funds to settle the derivative contract agreement. Hopefully, this basic, simplified example answers the question how do inverse ETFs work.