The ETF revolution allows everyday investors to achieve the impossible. Just a few short years ago, short-selling, leverage, spreads, and commodities were practical only for the Wall Street insiders. Now, with ETFs, anyone can play.

Yet availability doesn’t guarantee success. You have new opportunities, yes, but they all have risks. You need to know what can go wrong and be ready for it — before you place an ETF order.

Lately I’ve received many questions about inverse ETFs, which are designed to go up when the indexes they track go down. With markets volatile, the economy sputtering, and a global debt crisis all over the headlines, now may be a great time to consider trading on the short side.

But inverse ETFs carry some unique risks. And today I’ll talk about three you may not have considered.

Inverse ETF Risk #1:
Bad Timing

This one may go without saying, but I’ll say it anyway. You don’t want to buy an inverse ETF (or make any kind of short sale) unless you are very confident your target market is heading down soon. Timing your entry and exit is critical.

The same is true for bulls, of course, but it’s doubly important on the short side. Markets tend to fall faster than they rise. The downturn can easily be over by the time you notice it and decide to jump aboard with an inverse ETF.

Even for professionals, differentiating between a temporary drop and the beginning of a bearish trend is tough. And as we’ll see in the next section, time is not always on your side.

Inverse ETF Risk #2:
Holding Too Long

Many inverse ETFs include a built-in leverage factor. The intent is to amplify your gains by 2X or 3X. Sounds great, right? Go 3X short and a 5 percent drop for the market turns into a 15 percent gain for you, right?

Not exactly. In most cases, the leverage factor is reset every day. This means that, over time, the value of your shares can drift down even if the market moves in your favor!

I explained this just last month in What Silver’s Recent Plunge Teaches Us about Leveraged ETFs. And for more details and examples, see my 2009 column Understanding Leveraged ETFs.

The bottom line: Leveraged and inverse ETFs are intended for quick strikes. Get in and get back out as soon as possible. If you make a mistake, admit it. Don’t just sit there and hope for a recovery.

[Editor's note: For clear, concise alerts on when to get into a position — and when to get out — you should check out Ron's International ETF Trader service.]

Inverse ETF Risk #3:
Derivative Exposure

Inverse ETFs employ various techniques to get the correct market exposure. In many cases they include derivatives like futures, options, and swaps.

The main concern in derivatives is “counterparty risk.” These instruments are nothing more than legal agreements in which two parties agree to do specific things in specific circumstances. One party is you — or really the ETF manager, acting on your behalf.

In the case of an inverse ETF, the counterparty agrees to pay your ETF if the selected benchmark goes down. Likewise, the ETF will pay the counterparty if the selected benchmark goes up. Counterparty risk is the possibility the other side won’t make good on their bet.

Most inverse ETFs achieve their desired exposure by holding swaps. And it is important to note here, that swaps typically involve only the gains and losses in an index, not the base value of the index itself.

For example, if an index has a starting value of 100 and moves 2 percent, the swap only covers the 2 percent move (4 percent if it happens to be a 2x fund).

If the counterparty were to default, the ETF might not be able to collect on the 2 percent or 4 percent gain, but it would still have the initial cash representing the original index value of 100. This example is oversimplified of course, but I think you get the idea.

Counterparty risk isn’t unique to derivatives contracts. When you buy a plane ticket, for instance, you agree to give the airline a certain amount of money. They agree to have a seat available for you on a plane going to your destination at a defined date and time.

If you don’t pay for your ticket, or the plane takes you to the wrong city, then it is a form of “counterparty default.”

Defaults on equity swaps are very rare, but there is always the possibility that it could happen. This is one factor to consider when deciding whether an inverse ETF is what you need.

Every ETF has a prospectus with detailed information on its characteristics, fees, and risks. Always read it before you invest a dime. You can find it on the sponsor’s website. If you don’t understand something, get clarification from a reliable source.

Best wishes,

– Ron RowlandSource:  Money and Markets

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