Shorting ETFs

When and How to Short an ETF

Portfolio management and asset allocation concept

 William_Potter/Getty Images

As even beginner investors will tell you, stocks go up, and stocks go down. While less volatile than individual stocks, stock indexes also fluctuate between losses and gains. Seeing as many ETFs are comprised of stocks that track stock indexes, it makes sense that they, too, go up and down.

Despite this, many people considering investing strategies think only of how to buy an ETF. This is also known as "going long." However, ​there are two sides to every trade: a buyer and a seller. In some cases, the person selling (or "shorting") an ETF may be on the profitable side of the trade position. The key is knowing when to go long on an ETF, and when (and how) to short it.

Reasons to Short an ETF

There are four general reasons to consider putting on a short ETF position. Each of these reasons comes with its own pros and cons that should be considered.

Taking Profits

This is a favorite reason to sell an ETF among investors. For example, if you made a nice play on a solar energy ETF, and the price has significantly increased since you acquired the ETF, you can consider closing the position. This way, you lock in your gains. You can sell some or all of your long ETF position, depending on your investing strategy.

Hedging Downside Risk

There are many types of risks you can hedge utilizing a short ETF position. For example, general portfolio downside risk can be hedged using a market ETF. Or if you have downside exposure to a certain sector, an industry ETF or commodity ETF can help alleviate some of your risk. There are even ETF short strategies to hedge inflation and interest rate risk with currency ETFs and bond ETFs. Have downside foreign exposure? Choose from a vast pool of foreign ETF options. No matter your portfolio, your choices are plentiful.

Gaining Downside Exposure

On the other hand, if you feel you don't have enough downside exposure, ETFs can help. If you are bearish on a certain investment, sector, or market, putting on a short ETF position may present an opportunity to capitalize on your research. Once you feel you have captured the warranted amount of profit on a short ETF trade, you can always unwind by purchasing the ETF and offsetting the risk in your portfolio. Or you can lock in profits by using another ETF strategy to hedge the upside risk.

Hedging Trading Positions

For the advanced trading strategies, short ETF positions can be a way to hedge downside risk in a portfolio that contains index baskets as well as derivative assets like futures and options.

How Do I Short an ETF?

Once you decide you are ready to put on a short ETF position in your portfolio, there are two ways to accomplish your goals.

Sell an ETF

If you already own an ETF that you wish to short, the easiest and most obvious way to do so is to place a sell order with your brokerage. Like selling an individual stock, you can sell an ETF with a market order or a limit order. Market orders will execute quicker, but if the ETF is volatile, you may earn less than you anticipated from the sale. Limit orders ensure a minimum price, but the trade-off is that your order isn't processed as quickly. If the ETF's value falls below your desired price as you're waiting for your sell order to execute, it may not be filled at all.

Though significantly more complicated (and riskier), you can also take a bearish position on an ETF by short selling or trading options. Short selling involves selling shares that you do not own, then closing out your position by buying back the shares at some point in the future. A short seller believes the price of the ETF will drop, so they sell for the higher price now, then close out their position once the price of the ETF has actually fallen.

Another way to take a bearish position on an ETF is to buy a put option. When you do, you're buying the right to sell an ETF at a price that's more than you think the ETF will be worth. If you're correct, you get to buy the ETF at the lower, true value and then sell those shares at the higher price guaranteed by the put option. This is similar to short selling, but there isn't an obligation to execute the trade.

Buy an Inverse ETF

Trading options and short selling is risky, and depending on the kind of trade you're making, there's theoretically unlimited risk. That's why inverse ETFs were created. These ETFs inversely track indexes, so when the index in question loses value, the inverse ETF gains value.

This is less risky because, rather than buying or selling hypothetical future trades, you're buying an asset. The worst thing that can happen is that the inverse ETF you buy loses all of its value goes to $0. That's certainly no cause for celebration—you will lose the money you spent on the ETF—but at least you won't be on the hook for additional funds.

While inverse ETFs are generally less risky than options trading, they're still much riskier than traditional index ETFs. The U.S. government has issued warnings concerning the high levels of risk associated with inverse ETFs.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.