As markets become more volatile, it’s worthwhile to consider ways to protect long term portfolio holdings as well as how to profit in down markets.  To be sure, when early trading in overnight futures suggest a big open for stocks, such as is happening today, a column with a bearish bent may seem out of place.  But it’s never a bad time to consider your alternatives if the markets remain volatile and the down trend reasserts itself over the next few days to weeks.

The ProShares Ultrashort Biotech ETF (BIS) is a useful, but also potentially volatile and highly speculative, investment which is well suited for current market conditions based on its risk reward ratio.  We recommended BIS shares on June 10^th with a buy entry point below $42.  We are raising the entry point up to $43 in this issue and providing further details on why we recommended it, how it should be used, and what the advantages and dangers of owning leveraged inverse ETFs can be for investors who take their eye off the ball.

Inverse ETFs have been around for a few years, but many investors fail to appreciate their usefulness and their potential pitfalls.  There are two types; those that rise at the same pace that the underlying target index falls in price (one-to-one), and those that use leverage and rise 2x or 3x the rate of the price decline in the target index.   Since there is no one-to-one inverse biotech ETF, we use the ProShares Ultrashort Biotech ETF (BIS), which moves at twice the rate of the price change of the Nasdaq Biotech Index (NBI), to hedge our biotech portfolio against down side risk when market conditions warrant such a strategy.  Just to be clear, BIS moves in the opposite direction of NBI and at twice the rate. 

Why Buy BIS Now?

BIS is a risk management tool.  The stock market is flashing signs that a price correction has started and the Nasdaq Biotech Index has lost 10% since June 6, 2016, causing some of the biotech stocks that we own to fall in price. Since our biotech portfolio is made up of many stocks which we are looking to hold for the long term, owning shares of BIS will decrease the potential rate of loss of our long term portfolio holdings while the market corrects and hopefully save us the trouble and cost of selling stocks that could rebound rapidly at some point if we were to sell them prematurely.  If this is a quick correction our BIS sell stop will trigger the sale of the ETF and our long term holdings should rebound, returning the portfolio to balance.  Nothing is ever guaranteed in markets, but being cautious is usually a better bet than being reckless. 

Know what you’re buying

It’s important to know what you’re buying.  BIS moves at twice (2x) the price of the Nasdaq Biotech Index (NBI) for any one day. This relationship may or may not hold up over time. BIS does not own or short stocks. Instead it owns sophisticated options insurance contracts known as swaps, which are designed to rise in price when NBI falls in price, and are in turn allocated in the ETF portfolio mix specifically to deliver the 2x price movement on a daily basis.  The ETF, which is an investment company, buys the swaps from multiple brokerage firms and designs the portfolio around the asset allocation of the swaps.  Currently, BIS owns swaps purchased from Bank of America, Deutschebank, Credit Suisse, UBS and others.  There is always the potential with swaps that the counter-party won’t pay on the bet if it goes against them and that the daily price of the swaps won’t reflect the underlying market action.  Remember, the Sub Prime mortgage crisis bear market was triggered by the swap arrangements made between investors.   

Know the up and the down side of the trade

Biotech stocks are traditionally volatile. They tend to rise and fall as a sector, which means that any or all of the biotech stocks in our portfolio are at risk of falling when NBI falls, and the odds of them rising increase when NBI increases in price.  And since the trend of prices in a single direction – up or down – can often last for months or years, owning BIS gives us the chance of reducing the potential for losses in our stocks without having to hedge each of them individually or sell them prematurely.  Thus, the upside of the trade is that when biotech stocks fall, the odds are excellent that BIS will rise. And since biotech stocks tend to fall at a rapid pace, the potential for making big money through BIS when the NBI is falling is fairly high.  The downside of the trade, since BIS is a 2x leveraged fund, is that when the trend for biotech turns positive, the losses in BIS can mount rapidly. 

Here is how losses can quickly pile up.  Let’s say that NBI goes down 10% in a day from 1000 to 900.  Under normal conditions a $1000 position in BIS would be worth $1200 on that day.  But on the next day, NBI rises 10% to 990.  That would mean that the BIS position would be worth $960 since 20% of $1200 is $240. If NBI continues to rally, the losses on BIS would compound at a faster rate, which is why we only recommend BIS as a short term trade and use trailing sell stops as well as recommending adequate vigilance on the price action from subscribers that follow the strategy.

This is only a trade

Because losses will compound faster if NBI reverses course to the upside, this BIS recommendation is only meant to be a short term trade based on a falling trend in NBI,  which will be stopped out after a six percent loss based on the trailing stop that we have recommended. That means that a sustained 3.5% move to the up side by NBI should get us out of our BIS position.

Buy ProShares Ultrashort Biotech ETF (BIS) up to $43, and increase the Sell Stop to 7%.

There are no other portfolio changes for any of my other recommended stocks this week.