Short-term traders know that few investments, outside of options, will make or lose you money as quickly as an inverse ETF.

When you’re right, the upside can be spectacular … but when you’re not, the extent of the downside risk is astounding. This doesn’t mean that inverse ETFs need to be avoided at all costs, but it does mean that a disciplined approach is essential.

The key to trading inverse ETFs is to cut your losses quickly, and to use stops to eliminate any element of subjectivity when it comes to limiting downside risk. This can be said of any investment, but it’s particularly true in this case, for two reasons.

First is the nature of markets. It’s often said that markets “take the stairway up and the elevator down,” and that’s true more often than not. This means that inverse funds can lull investors to sleep by grinding through daily losses of 1%-1.5% over a period of several days, causing losses to mount as the investor waits for his or her original thesis to play out.

In many cases, that proves extremely difficult since nailing the timing on a downside move is difficult. Crestmont Research has calculated that the U.S. stock market rose in 53.6% of the sessions from 1950 through 2012, while falling in 46.4%. This means that investors who bet against the market are starting with the odds already tilted against them. This makes trading inverse ETFs akin to laying 11-10 odds in sports gambling, where any bet can be a winner … but the house tends to come out ahead in the long run.

The second issue is the well-documented tendency of inverse ETFs to track the market poorly over periods greater than a day.

While a triple-inverse fund might succeed in its stated goal of providing -300% of the move in the underlying index on a given day, tracking error tends to build up over time. For instance, the SPDR S&P 500 ETF (SPY) returned -3.8% in the second half of 2011. An investor may expect a 2x inverse ETF such as ProShares UltraShort S&P 500 (SDS) to provide a return in the neighborhood of 7.6% in that same interval. But in reality, the fund actually lost 6.5%.

This means the longer an investor hangs on to one of these funds, the more likely the odds that the negative impact of tracking error will begin to eat away at the value the investment.

Disciplined Inverse ETF Trading Offsets These Effects

While these two factors mean that the odds are stacked against those who trade inverse ETFs, investors can mitigate the potential risks through the obvious solution: using stops and sticking to them. By setting tight stops that prevent a loss of more than 4% or 5%, investors can offset the impact of the two factors noted above.

Further, by minimizing their drawdowns on losing trades, they will be able to get the full benefit of the positive returns that can occur when they manage to hit the trade just right.

The Bottom Line

The long-term SDS chart, shown below, encapsulates investors’ dilemma.

On one hand, how can you ignore an investment that can double in 18 sessions, as SDS did from Oct. 1-27 in 2008? On the other, the long-term chart shows an ETF that has generally traded from the upper left to the lower right over time.

The message is clear: Pick your spots, be nimble, be sure not to fall in love with your position, and by no means average down.

Inverse ETFs are sophisticated instruments, but the use of a simple strategy — employing stops — can make them work for you rather than against you.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.