Prechter explains how leveraged short funds beat pure shorts

Readers of ArabianMoney will know that this website has been a lonely champion of leveraged inverse, or short exchange traded funds as a strategy to profit from the major reversal in financial markets that now seems to be upon us after the long rally.

But in reviewing the latest edition of ‘Conquer the Crash: You can survive and prosper in a deflationary depression’ by Elliott Wave expert Robert R. Prechter Jnr, it was heartening to hear his conclusion: ‘If you can do it, then use these vehicles’.

200% short call

Recently Prechter has encouraged his readers to go 200 per cent short in US stocks (see this video). It would be unfair to quote his full explanation but we will summarize his preference for taking a position in short funds rather than setting up direct short positions.

There is an important difference in that short funds will compound, or roll-up their gains in a falling market, usually on a daily basis, whereas a gain in a single company short position can never exceed the value of the underlying asset.

So if you look at say SKF, a leveraged short ETF for US financials, it has collapsed in value since last March because of the downward effect of compounding. The important point to realize is that in a falling stock market, like the one that has most likely just started, then upward compounding will apply.

It is perfectly understandable that the downward compounding effect has gotten these instruments a bad name. They are ‘horrible instruments’ on the way down as Dr. Marc Faber told ArabianMoney last summer.

But what goes down must come up – especially if you are a leveraged inverse ETF designed to do just that. Mr. Prechter has seen the structural potential and gets quite excited about this.

Market risk

Of course, the risk is getting the direction of the market wrong, so you should never invest more than you can afford to lose in such funds, although they are not like options that expire worthless and will keep some residual value. The compounding can also run against you if markets are particularly volatile.

Some investors will say that they do not like trying to time the market. Well in that case you should not be in it at all. And staying long in a declining stock market is a suicidal strategy for any portfolio, so why not be brave and go short?

Short ETFs carry third party risk as ‘horrible’ derivatives so it is wise to spread your money around. There are plenty to choose from, and not all will fail, if any of them.