Hedging with Leveraged ETFs Part 2: How to Use Inverse ETFs Without Going Broke

One of the top questions I hear when it’s time to hedge is: 'I can’t short stocks with my broker; will using inverse ETFs like SQQQ or SPXU work the same?'

The brief answer is: They can provide strong protection and, in that sense, are similar to shorting. Actively managed ETFs were first authorized by the SEC in March 2008, during the height of the financial crisis. Inverse leveraged ETFs were quickly adopted by investors as an alternative to shorting, since borrowing stock became extremely difficult by the summer of 2008. From their inception, inverse ETFs were designed to serve as a tool for profiting in downtrends, much like shorting, but no, they won’t behave the same financially.

Before we go any further, I hope you’ve read part 1 of this post, which explains the decay associated with these ETFs. Understanding this aspect is crucial to hedging without getting burned by inverse ETFs.

Why it’s not the same

To keep it simple, let’s say you just started investing and the only stock you own is 1 share of TQQQ (a 3x leveraged ETF tracking the Nasdaq), valued at $100 that day. Now, you believe the market is about to enter a downtrend, so you want to protect your account without selling your TQQQ share.

Option 1 : short

You decide to borrow a TQQQ share from someone and sell it immediately (short) for $100 to protect your own TQQQ share. The market declines, bringing TQQQ down to $60. Now, believing the drop is over, you buy back the share you borrowed and return it, making a profit of $40, minus the borrowing fee (typically 0.3%-3% per year, applied daily). If this was done quickly (with minimal borrowing fees), your account remains roughly flat, still around $100 when you cover your short—though now your TQQQ share is worth $60 and you have $40 in new cash (taxable in most cases). Congratulations, you've successfully protected your capital.

Option 2: Inverse ETF

You cannot short, so you use the cash available in your account or go on margin and decide to buy SQQQ, a 3x inverse ETF that matches the daily volatility of your TQQQ share. To keep it simple, let’s say SQQQ is priced at $100 on the day you make the move, so you buy a single share. Now you have one TQQQ share at $100 and one SQQQ share at $100. The next day, the Nasdaq drops by 5%, causing TQQQ's price to shrink to $85, while your SQQQ share climbs to $115. Great! When the market closes, you pop open a bottle of fine cognac to celebrate your immunity from the market drop.

However, the next day, Powell gives an interview where, fueled by a fight with his wife the night before, he talks very hawkishly. The Nasdaq gets crushed again, falling another 5%. Your TQQQ drops from $85 to $72.25 (a 15% drop), while your SQQQ climbs to $132.25. This time, your account is not flat, and you’re up around 2.5% for the day. If the drop continues down to TQQQ at $60, like in the previous example, you will become increasingly “overhedged.” This reality is linked to the path dependence of leveraged ETFs (both bull and bear), which we discussed in part 1 of this article that focused on decay. This creates compounding in a steady uptrend that outweighs the decay on the other side of the pair. This is one reason I often use SQQQ to protect my capital during a real downtrend, even in my non-taxable account.

While shorting guarantees that (if the correlation is near perfect) your capital will remain at the amount you have in your account on the day you hedged, buying inverse ETFs (again, assuming the correlation is near perfect) theoretically guarantees that the amount in your account on the day you decide to buy SQQQ is the lowest you will see, regardless of the market trend (as long as a trend exists - and this nuance is important as explained later). If the market continues to decline, your SQQQ will become inflated, and your account will rise (somewhat similar to becoming net short). If you unfortunately bought the bottom, your TQQQ will outpace your SQQQ, and your account will slowly increase until you unhedge. For small drops, this may not make a significant difference, but during large declines, it can be an effective way to play the market trend.

For example, if you decided to buy $100,000 of SQQQ on December 23, 2021, to offset $100,000 of TQQQ, at the local bottom of June 16, 2022, your TQQQ would be worth only $24,390, while your SQQQ would have more than covered your losses by rising to $240,000. This would yield a very nice 32% gain—something impressive considering that the capital you had on the day you bought your SQQQ was effectively protected.

“As long as you have a market trend”

I emphasize above that for this strategy to work, you need to have a trend. This is linked to one last twist of hedging with inverse ETFs. Holding positions in two opposite ETFs (in my example, TQQQ and SQQQ) creates a path dependency that is not related to the leveraged aspect of the ETFs. This concept might be unintuitive to grasp, so here’s an example: If you have a $100 position in TQQQ that flips back and forth by -5% and +5% for 10 consecutive days, we know that due to compounding, our position would decay (since after a -5% drop, the +5% gain on your new smaller position will not bring you back to your initial capital). You might think that taking a $100 position in the opposite ETF (SQQQ) would make your portfolio neutral, like shorting TQQQ would, but that is not what will happen, as the next figure shows. It will actually decay.

So, if you make your portfolio neutral using inverse ETFs when you get your hedge signal, a real downtrend or uptrend will grow your portfolio, but any sideways movement will tend to cause it to decay. This will be accentuated by the infamous decay inherent to inverse ETFs, which will tend to push your portfolio's movement to the downside. In part 1 of this post, we discussed the sources of decay associated with the mechanics of leveraged ETFs. We can emphasize that inverse leveraged ETFs are more affected by decay than their bull counterparts. In fact, an analysis in Jian's thesis showed, from equation 2.2.4, that while every leveraged bull ETF experiences decay as a function of realized volatility (-1x realized volatility for beta=2 and -3x realized volatility for beta=3), the inverse counterparts always exhibit a greater decay correlation with realized volatility (-3x realized volatility for beta=-2 and -6x realized volatility for beta=-3). Let’s skip the math here: in brief, inverse ETFs perform worse and will never compound as much as the bull ETFs would in an identical opposite trend. Here is a picture that shows the SMA50 of the difference in daily return (percentage) between TQQQ and SQQQ during the first half of 2022.

We see that it is always in the negative, with the decline becoming more pronounced when the selloff began in 2022. This aligns with what I presented in my previous post and indicates that even if the portfolio were perfectly balanced, it could still decay.

These combined effects (path dependency and inverse ETF decay) can quickly cause your portfolio to dip below the value you had when you decided to hedge with an inverse ETF. For example, on November 21, 2021, buying 1 TQQQ (around $90/share) and 3 SQQQ (around $30 each) would have left you flat at a total value of $180. If compounding were symmetrical, we would expect to never dip back below $180 after that point, regardless of the market's direction. However, here is a graph of the reality. Initially, we were well-hedged, but we experienced continuous decay until the actual selloff began in January. Compounding then left us overhedged, but note how the rally at the end of March brought us back below our initial $180. As mentioned above, volatility will always create more decay in inverse leveraged ETFs than in leveraged ETFs. However, this isn’t a major concern since the subsequent massive downtrend quickly pushed us back into positive territory.

The solution: rebalancing

In a significant downtrend like the one we experienced in 2022, I’m not too worried about the decay of my inverse ETF-hedged portfolio since I know that the trend is strong and that compounding in SQQQ will outweigh the decay associated with realized volatility and the mechanics of inverse ETFs. Whenever you notice the trend pausing and starting to go sideways or reverse, a good strategy is to at least rebalance your portfolio to a neutral position. If you want to minimize risk, you can also rebalance at the end of each day. In this case, your portfolio will behave similarly to one that uses shorting to achieve neutrality. My previous example was straightforward since my theoretical portfolio only contained TQQQ and SQQQ. In reality, if someone is a tech investor, their account will likely hold a diversified basket of growth stocks. In this case, a simple way to rebalance your portfolio during a dip is to buy the equivalent bull ETF using the proceeds from selling the excess of their inverse leveraged position. Oof, this sentence is hard to digest… here’s an example of what I mean:

When this investor feels it is time to buy the dip for real, they can simply sell their accumulated QLD position and invest in their preferred stock. There will definitely be taxes involved in this strategy, like with shorting, but I’ll let you figure that part out since each country has its own rules.

Maybe some don’t want to constantly rebalance and be slaves to their portfolio during the dip, and that’s okay; Dr. Jiang Zhang has your back. In his PhD thesis, he also investigated different scenarios of rebalancing to achieve good tracking of the index (eliminate path dependency). He showed that rebalancing every five days leads to very good tracking of the index, and even doing it every three weeks yields good results (Section 2.5.2). The simulation was not necessarily in the context of hedging a portfolio during a drawdown, but I backtested the five-day scenario, and it was at least good enough for me.

Conclusion

Using inverse ETFs to hedge a portfolio is a very valid solution. As long as the correlation between the portfolio and the inverse ETF used is strong, and the portfolio is rebalanced, this approach can yield results similar to shorting the same assets. As discussed above, if the downtrend is clear, it can also be a good way to profit while protecting your capital.

I hope this information will help you become wealthy, but I think it would be more accurate to say, 'I hope this helps you avoid becoming poor.