What is an ETF?

Inverse Indicators

Update : May 12, 2014

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1. What is an Inverse Indicator?

An Inverse Indicator is an indicator calculated by multiplying the daily fluctuation rate of the underlying indicator (TOPIX, etc.) by a certain factor.

2. Traits of Inverse Indicators

(1) Traits

Inverse Indicators have price movements and returns that differ with those of regular indicators. The following is a specific explanation of the traits of TOPIX Double Inverse (-2x) Index.

  • TOPIX Double Inverse (-2x) Index is calculated so that the fluctuation rate will be -2x the daily fluctuation rate of TOPIX. Therefore, it will be -2x if compared to the TOPIX fluctuation rate for the preceding business day, however for periods longer than two business days, the fluctuation rate may be more or less than -2x that of TOIPX due to a compounding effect.
  • Particularly, in cases where TOPIX has repeated mutual rises and declines, the compound effect of TOPIX Double Inverse (-2x) Index is gradually decreased, causing returns to be more difficult to achieve.
  • TOPIX Double Inverse (-2x) Index is expected to produce even more dramatic returns when TOPIX is in a downward trend, making it particularly useful when such a trend is expected.

(2) Notes

<Example 1: A Downward Trend for the Underlying Indicator>

The graph below shows a case of TOPIX in decline. In such a case, TOPIX Double Inverse (-2x) Index will have a daily fluctuation rate equal to -2x that of the underlying indicator.
However, if a period of 2 business days or longer (Base date to 2nd day) is examined, whereas TOPIX fell 14.5% (100 to 85.5), TOPIX Double Inverse (-2x) Index rose 32.0% (100 to 132.0), producing a result that is not exactly -2x the fluctuation rate of the underlying indicator.
In this way, it is possible to aim for returns during a declining market using an Inverse Indicator. However, when compared over a period of 2 business days or longer, the rate of increase may differ from the expected fluctuation rate (-2x the underlying indicator). The longer the period of investment, the greater the possibility for discrepancy between the fluctuation rates of the underlying indicator and the Inverse Indicator.

<Example 2: An Upward Trend for the Underlying Indicator>

The following graph shows a case of TOPIX on the rise. In such a case, TOPIX Double Inverse (-2x) Index will have a daily fluctuation rate that is -2x that of the underlying indicator.
However, just as in Example 1, if a period of 2 business days or longer is examined, whereas TOPIX rose 15.5% (100 to 115.5), TOPIX Double Inverse (-2x) Index fell 28.0% (100 to 72.0), producing a result not exactly -2x the fluctuation rate of the underlying indicator.
In this way, the Inverse Indicator produces a decline when the market is on the rise. However, when compared over a period of 2 business days or longer, the rate of decline may differ from the expected fluctuation rate (-2x the underlying indicator). The longer the period of investment, the greater the possibility for discrepancy between the fluctuation rates of the underlying indicator and the Inverse Indicator.

<Example 3: A Trend of Repeated Gains and Losses of the Underlying Indicator>

The following graph shows a case of the underlying indicator TOPIX experiencing a series of gains and losses. In such a case, TOPIX Double Inverse (-2x) Index will again have a daily fluctuation rate that is -2x that of the underlying indicator.
However, though TOPIX has returned to the base date’s level by the 3rd day, TOPIX Double Inverse (-2x) Index moved from 100 to 96.0, not recovering to the base date value due to its compounded movements.
In cases where the market’s direction is unclear and the underlying indicator repeatedly rises and falls, an Inverse Indicator’s performance will be gradually decreased compared to that of the underlying indicator due to the compounding effect.

<Example 4: When an ETF/ETN's price in the market reaches the upper limit price >

The diagram below shows the price of an ETF/ETN tracking TOPIX Double Inverse (-2) Index reaching its upper limit price. While the price of the issue is capped at this upper limit price during the day, TOPIX Double Inverse (-2) Index may continue to rise beyond this level since it is not subject to quoting restrictions. This means that the issue cannot be traded in the market at or near its theoretical price if the theoretical price rises above the upper limit price.
Such situations where the price in the market is different from its theoretical price can occur for any ETF/ETN regardless of whether it tracks an Inverse Indicator. However, in the case of a leveraged Inverse Indicator, its leveraged nature means that an issue tracking the indicator would be more likely to reach the upper limit price due to the fluctuations in its market, creating a gap between theoretical and tradable prices. Investors should bear in mind that a higher likelihood of the tradable price deviating from its theoretical price.
Once the theoretical price of the ETF/ETN falls to or below the upper limit price, the price in the market will no longer deviate from its theoretical price.

<Example 5: When an ETF/ETN's price in the market reaches the lower limit price >

The diagram below shows the price of an ETF/ETN tracking TOPIX Double Inverse (-2) Index reaching its lower limit price. While the price of the issue cannot fall beyond this price during the day, TOPIX Double Inverse (-2) Index may continue to fall below this level since it is not subject to quoting restrictions. This means that the issue cannot be traded in the market at or near its theoretical price if the theoretical price falls below the lower limit price.
Such situations where the price in the market is different from its theoretical price can occur for any ETF/ETN regardless of whether it tracks an Inverse Indicator. However, in the case of a leveraged Inverse Indicator, its leveraged nature means that an ETF/ETN tracking the indicator would be more likely to reach the lower limit price due to the fluctuations, creating a gap between theoretical and tradable prices. Investors should bear in mind that this would result in a higher likelihood of the tradable price deviating from its theoretical price.
Once the theoretical price of the ETF/ETN rises to or above the upper limit price, the price in the market will no longer deviate from its theoretical price.

3. Differences in Profit/Loss with ETFs tracking Underlying Indicator

An Inverse Indicator moves in the opposite direction from the underlying indicator. In addition, due to the nature of leveraged Inverse Indicators, for example, an Inverse Indicator that is designed to double the fluctuation of the underlying indicator, an ETF tracking such an indicator will also result in larger gains and losses as compared to an ETF tracking the underlying indicator.

4. Notes on Investment Styles

  • In cases of medium to long-term investment, the disparity between the underlying indicator’s fluctuation rate and the Inverse Indicator’s fluctuation rate may increase greatly.
  • When market conditions are such that the underlying indicator will rise and fall repeatedly, the performance of the Inverse Indicator may be gradually diminished compared to the underlying indicator due to a compound effect, making profits difficult to achieve.

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