Monday, March 10, 2008

Contra-band: The Longs and Shorts of Contra-ETFs

On Friday I mentioned Contra ETFs as a way for conservative investors to hedge their portfolios in falling markets. For all of you novice investors, an ETF is an acronym for Exchange Traded Fund. Think of it as a mutual fund that trades like a stock, which is exactly what it is. The beauty of ETFs compared with mutual funds is that getting in and out of them is a lot easier since you don't have to wait until the end of the day to open or close your positions. The Spiders (SPY) and the Q's (QQQQ) are examples of ETFs that are activley traded and widely held. With that said, let's look at contra ETFs in more detail and discuss the best way to use them.

What is a Contra ETF?
A contra ETF is just what the name implies: It's an ETF that uses instruments that inversely mirror the movement in its underlying index or sector. There are two types of contra ETFs--short and ultra short. A short fund tries to exactly mirror the inverse movement of its underlying instrument while an ultra short fund mirrors twice the movement of its underlying. As an example, let's compare the SH (Short S&P 500) with the SDS, its ultra short counterpart. Since last October 11th's market high, the SH gained 21% while the SDS doubled that to 43%. Sounds great, eh? It is great when the market is going in your favor, but if it starts to go against you, the downside to the ultra short fund is magnified.

Contra ETF Characteristics
All ETFs trade on the AMEX (the American Stock Exchange). Some are optionable, some are a lot more liquid than others, and most of them pay dividends. The majority of contra funds are offered by a company called Proshares. (For a complete list of their products, please visit their website: Rydex has a few, too. Here's a list of the most active contra funds (those trading more than 150,000 shares/day) in order of decreasing volume along with their dividend yields:

[Note: All of the above ETFs are optionable except for the bottom three (PSQ, EFU, and SDD).]

How to Play the Contras
These funds can be used either for portfolio hedging or for speculation. If you're using them as a hedge against portolio risk, you would use them the same as for any hedging techniques. (See my recipes on portfolio hedging.) You would buy them at market tops or when the market is just starting to turn around. How much do you need to buy? That's entirely up to you, but if you want to maintain a market neutral position, you would need to buy a dollar amount equal to half of your long position in the ultra short ETF. For example, if you have $100,000 to invest, you would need to buy $33,000 in an ultra short ETF that mirrors your portfolio (say the S&P 500) and keep $67,000 in your long stock positions. If the market drops 10%, you would lose $6700 in the value of your stocks, but your SDS position (the UltraShort S&P) would increase by $6600, not including the dividend that it pays. You should also note that if the market keeps on dropping, you'll need to sell some of your SDS shares to maintain your neutral position to avoid being overweighted on the short side. The risk to this strategy is if the market goes up, you'll start losing money faster.

The other way to play these is for speculation. You think the market is going down and you want to profit from it, but you don't like the concept of shorting, you don't understand how to play put options, or you're trading in a non-marginable account (like some IRAs). Here you would just buy the ETF you liked the best and set your stop/loss point just above the value of the underlying's major resistance. For example, if you bought an S&P contra ETF today, your stop/loss point would be when the S&P crosses its 1300 resistance level.

Which of these funds do I like the best? I have to say that the chart of the QID, the UltraShort Qs, is the most compelling. It's been range-bound since the middle of January and just broke out today. I would ride this down at least until the OEX (S&P 100) tests its 565-570 resistance level. It's interesting to note that the contra ETFs in the energy and basic materials sectors (DUG and SMN) are showing signs of life. Perhaps these sectors that have been so stellar recently are starting to run out of gas? (Pun intended) If you're overweighted in these areas, now may be the time to put on a little protection and purchase these contra ETFs.

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