Consider a Position in Inverse Funds

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October 18th, 2006

October 18, 2006 - As I’ve mentioned many times before, I expect to see a significant correction coming soon in the U.S. markets. Were it not for the imminent mid-term elections on Nov. 7^th, I would call for strong and steep corrections to start within the next couple of weeks. However, the looming presence of the mid-term elections clouds the entire picture. So what’s the solution?

Of course you can consider puts on the S&P 500 and DJIA, but the only problem with puts is that if you miss time your entry by just one or two days, you could be hurt badly. However, due to the wildcard of the mid-term U.S. elections, I believe that inverse funds are the better call. Inverse funds are not nearly as volatile as options yet provide downside protection. Two companies that offer inverse funds are Rydex Funds and ProFunds.

Both Rydex and ProFunds offer inverse funds for the S&P 500 and the DJIA that move directly proportional to these two indexes. For example, if the S&P 500 moves down 10%, and you own the ProFunds Bear Fund (BRPIX), then your inverse fund would move higher by 10%. For the more daring, Rydex offers a Dynamic Dow Inverse Fund (RYCWX) that moves 200% in the opposite direction of the Dow.

Minimum investment levels for ProFunds inverse funds range from $5,000 to $15,000 while Rydex funds have a higher minimum investment level of $25,000.

Again, the reason to consider inverse funds versus directly buying puts on the Dow and S&P 500 (or even the Russell 2000) is the following: With inverse funds, (1) you have more cushion to be a little bit off in your entry and exit timing that you would with options; (2) with a directly proportional inverse fund, you will have a less volatile ride than with put options; and (3) with puts, 100% of your play is at risk, while with inverse funds, it’s unlikely you will ever lose 100% of your stake.

2 Comments Add your own

1. Frank | October 18th, 2006 at 10:26 am

I think the market rally will still have some legs for the balance of the 4th quarter. I think this will be seasonal again, with the correction coming after the holidays at the earliest.
2. J.S. | October 19th, 2006 at 5:01 am

Frank,
You may very well be right but due to the mid term elections, some of the seasonal patterns have not held true (though the historical mid-term election patterns have). I’d just rather be a little bit early when buying protection rather than late because when profit taking starts in ernest I think it’s going to be a rapid descent whether it’s tomorrow, right after the mid-term elections, or two months from now. Inverse funds don’t have the huge “time decay” of put options so since timing is still cloudy, that’s why I recommend considering inverse funds now.