I received this question from a viewer regarding Inverse ETF's versus Puts;
I read a lot of blogs on a regular basis. Quite a few of them have been suggesting inverse ETFs to protect yourself against a market down turn.
I have not seen a single article detailing the pros and cons of protecting yourself using inverse ETFs vs. puts. Should you care to detail such pros and cons, I, and presumably your other readers, might find the article useful.
p.s. I have also read on other blogs that these double inverse ETFs have a less than stellar performance record - they tend to go down twice as much when the market goes up, but go up only 1.5 times when it goes down - making them a bad risk/reward solution.
This is a really good question, and my answer may deal more with preference than anything;
A Put buyer is betting that a particular security or index will decline in value within a pre-determined period time.
Since options expire the 3rd Friday of every month, a Put buyer must be not only be right about the direction of the market, but the time frame of when the decline will occur. If the Put buyer timing is not accurate about the time and direction, the premium (money) paid for the Put will evaporate rapidly.
In addition, option pricing is highly subjective, and to be frank, somewhat of a mystery.
Market Makers use the Black-Scholes Pricing Model to find the "theoretical" value of an option. The model tries to determine future volatility, which is nothing more than a guess. So, with time working against you, and the price paid for an option being nothing more than a guess, your odds are not very good.
Also, Market Makers adjust options prices according to supply and demand. If there are more Put buyers than sellers, the price of the option will rise.
I do not like buying Put or Call options for these reasons.
Inverse ETF's, on the other hand, do not have an expiration date. While twice (200%) the daily inverse (opposite) funds can expose an investor to dramatic gains or losses, an ETF inverse fund never expires. If an investor is wrong about timing and direction, they can simple set a stop loss, or add to their position and wait.
You are right that many inverse funds have only achieved 1.5 times the gain, and 2 times the loss. This has a lot to do with the make up of underlying securities inside the fund which results in an imperfect correlation to the underlying index.
When you read the description of a inverse or bull fund, they use the phrase "seeks to achieve", which in my opinion is better than the wording they use with options which are "tries, theoretical, and future volatility".
A managed inverse fund does not have to commit 100% of the funds assets to the underlying index. They can place a portion of the assets in bonds and money markets for future use. Also, if the fund manger determines that the market is working against them, they can roll their option or futures contracts forward to another month. This strategy helps to stabilize the portfolio value, and unlike options that expire worthless, you do not lose all your money if the market works against you.
These are the primary reasons I like using inverse funds over options. At least if my timing is a little off, I still stand a chance to profit.
