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How Short ETFs Make Money

Editor's note: Ask TheStreet is designed to answer questions about the market, terms, strategies and investment methods. Please email us to ask a question, but keep in mind that we cannot offer specific investment- or stock-related advice.

I am now looking at some of the short and ultra-short ETFs as protection against a bear market. But I cannot get a handle on how these make money. Do they short the individual stocks in the index they track? And exactly how do the ultra-short ETFs try to double the return? -- E.W.

The short and "ultra" (or "double") short ETFs ( exchange-traded funds ) offer a new way for investors to short the market while taking on less risk than shorting stocks outright.

About Shorting Stocks

Investors sell stocks short when they believe the market will go lower. Instead of buying low and selling high, the short-seller does the reverse: He sells high, and then, after the market has fallen, buys low.

Typically, when an investor shorts an individual stock, he or she needs to set up a margin account . Then, because the investor doesn't own the shares , he or she needs to borrow them from a broker in order to sell them. For this loan, he pays the broker interest. The short-seller sells the shares on the open market. He profits if the market falls so he can buy back the shares at a lower price.

However, short-sellers take on a lot of risk to hold a short position . If the market rises, the short-seller takes a loss by buying back the shares at a higher price. When you buy stocks, your maximum loss is the amount of your investment. But when you short stocks, your potential loss is endless.

Short ETFs

ProShares Advisors and Rydex Securities are currently the only companies issuing exchange-traded funds that short the U.S. and foreign stock markets. These ETFs go up in price when the market goes down.

Short ETFs, such as the ProShares Short S&P500 (SH), return the inverse, or opposite return of the index they are trading, which in this case is the S&P 500 Index (SPX). The ultra-short ETFs, such as the ProShares UltraShort S&P500 (SDS), return 200%, or double the negative return of the stock index, before fees and expenses. So if the S&P 500 falls 1%, the UltraShort S&P500 earns 2%.

"This is shorting made easy," says Michael Sapir, CEO of ProShares.

Among the many benefits to buying short ETFs is they're easier to trade. The investor doesn't need to set up a margin account or borrow shares or pay interest. In addition, the ETFs eliminate a lot of the risk involved in shorting. Instead of selling first and opening himself up to unlimited losses, the investor buys shares of the short ETF. The short ETF will rise when the market falls. He only risks the purchase price of the investment.

Press Your Bets With Leveraged ETFs

So, how do the ETFs do it? Well, for one thing, they don't short the "basket" of all the component stocks in the index. Rather, they use derivatives that don't have the trading costs associated with shorting.

These derivatives include index futures contracts and swap agreements, which are contracts between two parties to exchange an income stream. The index futures are sold, or sold short. The ETF also buys swaps with a negative correlation to the index; this is essentially shorting the swaps.

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