Can You Short an ETF and How Is It Done?

Exchange Traded Funds (ETFs) are investment vehicles that hold collections of assets like stocks, bonds, or commodities, and trade on stock exchanges throughout the day, similar to individual company shares. These funds offer diversification and liquidity, allowing investors to gain exposure to various market segments or investment strategies. Investors often inquire about the ability to take a bearish stance on these funds. It is possible to short ETFs, allowing investors to profit from a perceived decline in the value of the underlying assets. This strategy is employed when an investor anticipates a downward movement in a market segment or industry an ETF represents.

The Concept of Short Selling ETFs

Short selling is a financial strategy employed when an investor believes a security’s price will decline. This involves borrowing shares, selling them in the open market, and then repurchasing those same shares at a lower price to return them to the lender. The profit in a short sale is the difference between the initial selling price and the lower repurchase price, minus any associated costs.

This fundamental concept applies directly to ETFs, as they trade on exchanges just like individual stocks. An investor short selling an ETF anticipates its market price will fall, allowing them to buy back shares at a reduced cost. The profit is the difference between the initial sale price and the lower repurchase price, after accounting for borrowing fees. This approach is a bearish strategy, reflecting a belief that the value of the ETF’s underlying holdings or the market segment it tracks will decrease.

Executing a Direct Short Sale of ETFs

To directly short sell an ETF, an investor must establish a margin account with a brokerage firm. Regulatory bodies, such as the Federal Reserve Board and FINRA, govern the requirements for these accounts, ensuring sufficient capital is maintained to cover potential obligations arising from borrowed securities.

The process begins with borrowing ETF shares from the brokerage. Brokers typically lend these shares from their existing inventory, from other clients’ margin accounts, or by borrowing them from other firms. A borrowing fee, often interest on the value of the borrowed shares, may be charged. Once borrowed, these shares are immediately sold in the open market at the current price, and the proceeds are deposited into the investor’s margin account.

To close the short position, the investor must purchase an equivalent number of ETF shares in the open market. These repurchased shares are then returned to the lender. The margin account acts as collateral, ensuring the investor has the means to cover potential losses and borrowing costs.

Initial margin requirements for short sales are 150% of the short sale’s value, meaning 100% from sale proceeds and an additional 50% from the investor’s capital. For example, shorting an ETF worth $10,000 would require $5,000 in additional capital. Maintenance margin, the minimum equity that must be maintained, ranges from 25% to 40% of the current market value of the short position. If account equity falls below this level, a margin call may be issued, requiring additional funds or liquidation.

Leveraging Inverse Exchange Traded Funds

Inverse Exchange Traded Funds (Inverse ETFs) offer an alternative for investors seeking to benefit from declining market values without direct short selling. These funds are designed to deliver returns that move in the opposite direction of a particular index or asset class they track. For instance, if the underlying benchmark declines by 1% on a given day, an inverse ETF aims to increase in value by approximately 1% before fees.

Instead of borrowing and selling individual shares, inverse ETFs achieve their inverse exposure by utilizing various financial derivatives. These instruments commonly include futures contracts, options, and swap agreements. Fund managers strategically employ these derivatives to create a portfolio that inversely correlates with the chosen benchmark’s performance.

Inverse ETFs typically rebalance their portfolios daily to maintain inverse correlation. This daily rebalancing means their performance over longer periods may differ from a simple inverse of the underlying index’s performance. Investors can purchase shares of inverse ETFs through a standard brokerage account, similar to buying any other ETF or stock, eliminating the need for a specialized margin account or the complexities of directly borrowing shares. These funds provide a straightforward way to express a bearish market view on a broad market index, a specific sector, or a commodity.

Utilizing Options and Futures for Bearish ETF Positions

Options and futures contracts provide additional avenues for investors to establish a bearish position on an ETF, offering flexibility beyond direct short selling or inverse ETFs. These derivative instruments allow for a more tailored approach to expressing a negative market outlook.

Purchasing put options on an ETF is one such method. A put option grants the holder the right, but not the obligation, to sell a specified number of ETF shares at a predetermined price, known as the strike price, on or before a set expiration date. An investor acquires a put option anticipating the ETF’s price will fall. If the ETF’s market price drops below the strike price, the put option increases in value. The profit materializes either by selling the put option at a higher price than its purchase cost or by exercising the option to sell the ETF shares at the higher strike price and then buying them back at the lower market price. The initial cost of the option, called the premium, represents the maximum potential loss if the ETF price does not decline.

Another derivative instrument for bearish ETF positions is the futures contract. An ETF futures contract is a legally binding agreement to buy or sell a specific quantity of an ETF at a predetermined price on a future date. To express a bearish view, an investor would “sell” or “go short” an ETF futures contract. This action implies an agreement to sell the ETF at the specified future price, with the expectation that the actual market price of the ETF will be lower at that future time. If the ETF’s price decreases by the contract’s expiration, the short futures position can be closed by buying an offsetting contract at a lower price, or by delivering the ETF at the higher agreed-upon price, resulting in a profit. Futures trading also requires maintaining a margin account, where the margin for futures, often referred to as a performance bond, is typically a smaller percentage of the contract value compared to equity short selling.