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I have been looking to invest in the stock market and while there are plenty of options to invest as long as the market keeps going up, my options to cover or even make up for my losses in the event of a switch to a bear market are somewhat limited.

As a new customer, my broker won't allow me to open a margin account. So selling stock short is not an option for at least a few months.

At first I looked into inverse ETFs and leveraged inverse ETFs but they have a few issues. To me the most important shortcoming is that they fail to track their nominal target accurately. So I could have my shares and my inverse ETF go down or the ETF go up but severely lagging the market.

Then I came across inverse ETNs and they look like a great deal. I get perfect inverse index tracking and I can buy smaller lots to balance my small portfolio more accurately.

I can see how ETNs aren't really investing, but then neither are shorts. I also understand that the bank behind them can go belly up and then I lose any money I threw into their bucket. And I acknowledge that I may be unable to sell/buy them at a given price due to low volume.

However, I am left wondering where the fear comes from. As I see it, at worst I can only lose 100%+commissions out of my original "investment" and that makes them infinitely less risky than options and margin.

Additionally, I don't know for other exchanges, but the local stock exchange requires that all listed ETNs come from an A- rating or better financial institution with $5 billion+ net worth, and that they have at least 5 years to go until maturity.

Given that, is the risk for ETNs on a different order of magnitude compared to say, regular stock? Are they even less safe at all? Should I worry more about ETNs than some CEO announcing his company's phones cause cancer? Am I missing something?

  • I have added a country tag for you, please correct if this is wrong. – Victor Apr 3 '14 at 20:57
  • "To me the most important shortcoming is that they fail to track their nominal target accurately. => absolutely on the long term - but on a short term basis you more or less get what you expect. If you really want to exactly track the underlying (negatively), without leverage/margin risk, you could simply short a fully funded index future. – assylias Apr 3 '14 at 21:16
  • @Victor I figured I'd better ask the question in a way that is useful to more people. On the other hand, the tax code here treats ETNs exactly like stocks so if an answer depended on more favorable taxation, it'd be certainly less useful to me. – xdr Apr 3 '14 at 21:26
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    @xdr - tax is not the only reason to have a country tag. Some products may not be available in certain countries, and other countries may have special regulations in regards to certain financial products. If you do not have a country tag most answers will assume you are in the USA. – Victor Apr 3 '14 at 21:33
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From Investopedia:

One factor that affects the ETN's value is the credit rating of the issuer. The value of the ETN may drop despite no change in the underlying index, instead due to a downgrade in the issuer's credit rating.

Some other options you could consider to achieve your hedging requirements:

Have you considered buying index put options where your outlay and maximum loss would be much less, or if your country allows them, shorting an index CFD as CFDs do not have any expiry date.

Options have the benefit of knowing what your maximum risk and loss will be from the start, your option premium. However, their biggest disadvantage is their limited expiry date. You could buy a longer dated option but would pay a higher premium for it.

CFDs on the other hand have no expiry date, have very low commissions, if you are shorting an index you pay no overnight funding costs and track the index perfectly. They do however have an unlimited downside if the market turns against you and you could lose more than your initial margin (outlay). This can however be managed by the use of stop losses and if the broker has them guaranteed stop losses (where you are guaranteed the stop price you select and will not be gapped, for an extra charge of course).

Another option is to have stop losses on your shares and just getting out of the market to cash if the market changes to a bear market.

  • I hadn't paid enough attention to that. It is a valid concern. As for the alternatives. As I stated in my question I can't short anything at the moment and options trading requires that I have a margin account besides additional guarantees. I am looking for something I can do now and then move on to better options if they become available. – xdr Apr 3 '14 at 21:52
  • See in Australia, where I am from we don't need a margin account for trading options, and CFDs are freely available also with no margin account. Have you checked with other brokers what their requirements are? – Victor Apr 3 '14 at 21:56
  • Point taken, but my question is more about why shouldn't I buy ETNs rather than what should I buy instead. – xdr Apr 3 '14 at 22:09
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    Well that was my first point, they don't match the index exactly and can fall in price even when the market falls, due to issues with the issuing bank. Have you considered having stop losses on your shares and just getting out of the market to cash if the market changes to a bear market? – Victor Apr 3 '14 at 22:19
  • Another option that should be named are covered warrants, similar in style to options, and which happen to be available for regular investment accounts in Japan.I am going to accept your answer because it is true. Even with the anecdote that the ETNs have had the best returns for me. – xdr Jun 4 '14 at 15:09

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