Short-Sale Restrictions and Inverse ETFs

As soon as I saw the list of 799 financial stocks which were banned from shorting I was surprised that the financial ETFs, both long and short/inverse, were not of the SEC's list. It struck me as very odd that the inverse instruments were still trading yesterday (they were halted for some time) and that I was still able to borrow XLF. If they continue to trade (who knows if they'll be restricted at any moment) I'm sure many traders will put their focus there. There's an article on Morningstar's site that delves into some of the issues surrounds these ETFs and gives some ideas on how or if to use them.

Following the announcement of the ban on short sales, two ProShares inverse funds (including the widely held UltraShort Financials ProShares (SKF) ceased trading for a couple hours this morning in order to give the issuer a chance to sort through the implications of these government actions. In this article, we will attempt to shed some light on the situation by addressing the major questions about what happened this morning and how the Securities and Exchange Commission's restriction on short selling financial stocks will affect exchange-traded funds in the future.

A key part of the article:

In our opinion, the only hope of clearing this up before Oct. 2 is either an SEC clarification that broker/dealers can short stocks to hedge derivatives bought by ETF market makers, or a change to the ETF prospectuses that allows the funds themselves to short stocks directly.

What else can I do in the meantime?

Although investors cannot currently short sell individual financial stocks, there is no ban on shorting ETFs that court exposure to the sector, such as the Financial Select Sector SPDR (XLF) (long financials) or the Ultra Financials ProShares (UYG) (double-long financials). Individuals could short UYG instead of buying SKF, although we'd note that this leaves open the potential for bigger losses over multiday periods due to the compounding of leveraged daily returns. The Rydex Inverse 2x S&P Select Sector Financial (RFN) is still trading and creating new shares, although it is also likely to have trouble finding willing counterparties if it faces a wave of new assets flooding in to short financials.

Investors who already own SKF or SEF can sell the funds at any time because trading has recommenced, and since redemptions are still allowed, there is little risk of selling at a discount. In fact, there may be a good chance of selling at a significant premium sometime before this situation resolves itself.