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Six Broad Based ETF Trades for Bears


If you believe there will be a pullback in the short term, here are six trades to consider.


Editor's note: The following is from the "Trading with ETFs" section of the newly launched Buy & Hedge ETF Strategies premium section on Minyanville. Learn more and take a two week free trial.

For believers that the run up by 14% since Thanksgiving is to high and too fast for the market's own good, here are a few ways to trade a pullback in the near term.

The last few days have shown us that the battle between the bulls and bears rages on in a tight range. As earnings begin to be a mixed bag, perhaps it's time for the market to take a breather from the impressive 14% run its has since November 25, 2011.

Trend followers will tell you that the higher highs and higher lows are beginning to create a defined upward channel, and the 1280 SPX resistance level, defined in late October 2011, was passed without a hiccup. Throw on top of that the fact that the 50-day moving average is about to cross the 200 day, aka a golden cross, and that the Nasdaq 100 (NDX) hit an 11-year high this week all set up a pretty strong case for a bull market.

But even uptrends have lows, so from a trading perspective there's money to be taken off the table. With yesterday's Fed notes release, we heard that low interest rates will be sustained through late 2014; we can interpret that they aren't buying the recovery story. Add to that the fact that Europe is in the news again. So look for the currency trade to pressure near-term gains.

Yes, yesterday the market popped on the news of lower interest rates, as it usually does, but the telltale sign that this up day will be short-lived is seen in the inflows to corporate bonds and the high dividend stock in the utilities and staples sector.

If you are a believer that there will be a pullback in the short term, here are six trades to consider.

As a reminder, here's the Buy and Hedge Trading Checklist from that we follow for all trading activities.

Trade 1: The Vanilla Scoop – Long SH

(SH) is the ProShares Short S&P 500 ETF. This is not a leveraged ETF, but simply an inverse. That means that it has a target for a 1 for 1 inverse correlation to the performance of the S&P 500. However, the ETF still does slightly underperform due to factors like fees and dividends.

A look back to Jan 25, 2011 to today shows a move from 42.15 to 38.25, a decline of 9%. Compare this to the move in the SPY from 129.17 to 132.56, a 2.5% gain with a 2% dividend over the same period. An owner of SH should have expected only a decline of 6% in this scenario.

However, all that being said, if the market goes down, this ETF will go up. That's why this is a trade, not a long-term investment.

This is the simplest way to play a down market. It doesn't require borrowing for shorting, so it can be used in on a non-margin basis for account types like IRAs.

Going long SH, traders should look for a quick pop to the 39.75 – 40 range and if it breaks above that a continuation approaching 42. It's worth noting that the upper trend line has a negative slope. This is because we need to incorporate the declining nature of the inverse ETF and don't want to find we've set sell limits too high.

Click to enlarge

As for setting protection to the downside, this ETF is at an all-time low, so we have no real level of support to use guidance. However, since this is only a 1x ETF, we'll use our normal 10% below market mark for a broad-based ETF. That's around $34. Since this is a short-term trade consider the March puts for protection. Currently the 36 strike SH puts are going for 0.15 which is a pretty small amount to limit losses to under $2.50.

Trade 2: Using Leveraged ETFs – Long SDS or BGZ

Depending on how many scoops of leverage you like, you can choose from ProShares UltraShort S&P 500 (SDS) which is a 2x inverse ETF, or Direxion's Large Cap Bear 3X (BGZ) which, as the name suggests is a 3x inverse ETF. Both of these intend to negatively correlate to the daily change of the S&P 500.

For those of you who have heard of the downside to leveraged ETFs now is the time to remember that. For those of you who heard it but ignored it so far, pay attention.

These are short-term trades. That means if you just decide to go long, unprotected and it moves against you, you should be out within a week. If you catch lightning here, then a little longer is tolerated and will pay off. But I repeat, this is a week-long trade max for an unhedged losing position.

Why is that? The answer is because as time moves on these ETFs will depreciate due to simple math. We refer to this math as negative compounding. There's plenty of information on this all over Minyanville, so do your homework. I can't stress this enough about long leveraged ETFs. The chart below shows how the depreciation of long bear leveraged ETFs will severely underperform the broad index they intend to correlate to.

With a 2.5% gain in the SPY plus dividend puts it at a 4.5% gain. That means SDS should have been down 9% and BGZ down 13.5%. Instead you can see the results are dramatically different. This is why we don't stay in the trade long term.

If you're going to get into these on a a short-term basis, there is room to make money. The upside and limits are very similar for both of these, so here is a chart of BGZ and it's easy enough to set similar limits on SDS. If we get a short-term correction in the broad markets, BGZ should reach 27 relatively quickly and proceed to 32 if it's sustained.

Click to enlarge

Just like with SH, BGZ is at an all-time low, so there are no historical levels to determine support. However, right now the options market is pricing put protection at an affordable rate, so look to spend only $0.20 (<1%) here at the 20 strike price in March to limit losses to under $5.

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No positions in stocks mentioned.
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