Not Too Late to Hedge With Inverse ETFs

This column was originally published on RealMoney on March 7 at 2 p.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

On Monday, my indicators were confirming an intermediate-term downtrend in the market. The market looked very oversold and due for a sharp bounce sometime this week.

That bounce appeared big-time on Tuesday, fueled by a heavy amount of short-covering. The action was a classic sign of traders getting caught in a short squeeze when the market gaps higher in the morning. When the market didn't pull back in the afternoon and continued to go higher, it forced traders to buy back the stocks they shorted to prevent giving back all of their gains.

This mistake is often made by traders who are anxious to short the market at the first sign of any weakness. In a crash scenario, taking this type of action could be very profitable. However, that doesn't happen very often, especially when the market is just off all-time highs.

It's often better to short into rallies that fail into resistance levels, such as the 50-day moving average. When a market index or stock rallies back up to those levels on decreasing volume and then starts to resume its decline, it's often the best time to initiate short positions.

As far as Tuesday goes, the Dow Jones Industrial Average, the S&P 500 and the Nasdaq all held their 150-day moving averages to the penny. But the key is how the market acts over the next several days. If we get a strong follow-through to the upside on increasing volume that takes us above the 50-day moving average on all three major indices, this correction may have just been a pause in the prior uptrend. If the indices drift higher on low volume and roll off resistance, we probably will have more downside testing to go.

In past columns, I've discussed using inverse exchange-traded funds to hedge positions when the market becomes volatile, or to short the general market outright. On Jan. 29, I gave levels that looked like good spots to buy the ProShares inverse funds on the three major indices in the event of a downturn. Investors who did just that are probably sitting on some pretty good profits. But there are still options available to those who didn't.

Before we take a look at the charts, I want to warn you that a lot of traders are waiting to short this bounce, which may make the action harder than normal to gauge. We may get some more upside testing than normal, but I don't see the move getting much past the 50-day moving averages. But we'll let price and volume dictate.

Let's take a look at three of the inverse ETFs that cover the major indices.

The ProShares Short Dow30 fund(DOG Quote) represents the inverse of the Dow Jones Industrial Average. The rise or fall of this fund should roughly equal the Dow's moves, in their inverse.

If you missed this fund's breakout above the $63 level, you may have another opportunity to enter it on a pullback. Look for its price to retreat back to that level on decreasing volume. If it holds in that area and then starts to move higher, it may be time to take a position. And in that case, I'd also immediately put a protective sell-stop underneath the low of a pullback.

The other way to play this would be to initiate a position on a move above $66 with a protective sell stop beneath the $64 level.

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The ProShares Short S&P 500 fund(SH Quote) is the inverse fund to use to benefit from lower prices in the S&P 500. A good place to initiate a buy position would be near the $63 support level. Again, I'd wait for price to come down on lower volume and then start to head back up. Then I'd set a protective sell-stop below the pullback low.

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The ProShares Short QQQ fund(PSQ Quote) is the inverse fund for the Nasdaq 100 Unit Trust(QQQQ Quote). This index also has a solid base to buy off. I'd like to see the shares pull back to the $63 level and then bounce before taking a position. A sell stop would go below that level.

These are just a few ways to take advantage of lower prices in the market. ProShares also offers ultra-short funds that represent twice the move of the indices that they track. However, this is something only experienced traders should use, and if I did use it I'd make sure I had close protective sell-stops on all positions.

Short-term and intermediate-term indicators still point to lower prices. But because the longer-term indicators are still positive, I'd only use these funds as hedging instruments at this point. If the market continues to weaken and the indices begin to break major support levels, I'd become more aggressive. Until then, we'll have to see how the current bounce plays out.

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Please note that due to factors including low market capitalization and/or insufficient public float, we consider the ProShares Short S&P 500 fund, the ProShares Short QQQ fund and the ProShares Short Dow30 fund to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.