How to Short Stock In An IRA

Warning! I am not a tax advisor or a CPA. You should talk to a tax advisor if you are looking for definitive answers.

Shorting Stocks In Retirement Accounts With ETF - Exchange Traded Funds

Money in retirement accounts can almost seem like a burden when you're sure the stock market is overvalued. By early 2007, I was out of stocks and keeping both my traditional IRA and SEP IRA in cash, which sat in the brokerage's money market account earning a few percent. I didn't want to buy into a commercial bond fund despite the higher returns because I was worried about the share value of bond mutual funds falling when the economy turned sour and people bailed out. I still have that same worry in 2010 and only wish I could figure out an efficient way to short bond funds for the long run - they are going to go down. The problem is that you can't directly short stocks in brokerage retirement accounts and trading on margin in IRA's is out of the question. But the loophole that allows you to directly bet against the stock market in a retirement account is the wide availability of Exchange Traded Funds (ETF) that place the bets for you, yet trade like regular stocks.

I've bet against the DOW, the S&P 500 and the NASDAQ 100 using ProShares funds. I've stuck with the original short ETFs, the ProShares 1X funds which have reasonable management fees and pay a dividend that may offset that fee. The three funds I've had the most experience with are SH, the S&P 500 index short fund, DOG, the DOW index short fund, and PSQ, the NASDAQ 100 index short fund. I made great returns in the one IRA account I held these ETFs during 2008, but unfortunately, I stayed short right through 2009 and lost back what I made before getting out. There was a huge ex-dividend paid by many ProShares funds in late 2008, on the order of 10%, which doesn't hurt IRA holders (other than having to do something with the money) but came as a shock to folks holding the funds in taxable accounts. The prospectus for the funds comments that the long funds should have positive yields and the short funds should have negative yields, but I haven't seen this to be the case.

There has been some speculation circulating on the web that some of the 2X funds may have tax consequences, even within an IRA account, as they wouldn't be legal holdings, but I haven't read anything definitive, and other articles directly contradict it. The reports don't make a lot of sense to me, the "leverage" employed by 2X and 3X funds is not leverage in the normal sense, and there's no way I'm aware of an investor could make sure that any fund or stock owned in the course of a year isn't using leverage in some way that would violate IRA rules in the same sense. Fortunately, I'm not a tax advisor:-) There's also an issue with unrelated business income if you buy a fund that's structured as a limited partnership, though again, it's unclear whether the IRS applies this to individual retirement accounts or just trusts and charities. Currently, only twelve ProShares funds (I've spoken with them) have the potential to create unrelated business income and trigger a K-1 filing. These are the four currency shorts and the eight commodity shorts. The ProShares rep I spoke to was fluent on the subject, while not giving tax advice, it was clear that he hears these questions all the time.

An important note about fund tracking. Each ETF is designed to track the DAILY performance of the underlying index, whether 1X or 2X, positive or inverse. Tracking on a daily basis does not mean the same thing as tracking over a week or a month. To create a simple example, let's say that QQQ opened the week at 1000 and QID, the double inverse, opened the week at 2000. On Monday, QQQ rises 10% (I'm using big numbers to make the math obvious), and closes at 1100. Ideally, QID rises 20% and closes at 21200. On Tuesday, QQQ falls 5% and closes at 1045. QID falls 5% and closes at 1180. On Wednesday, QQQ drops 10% to close at 940.5, and QID drops 20% to close at 864. On Thursday, the NASDAQ 100 shoots up 15%, bringing QQQ to 1081.58, while QID jumps 30% to 1123.2, and on Friday, QQQ drops an engineered 7.543%, which brings it back to 1000, where it started the week.

Day Monday Tuesday Wednesday Thursday Friday

QQQ open 1000 1100 1045 940.5 1081.58

QID open 1000 1200 1080 864 1123.2

QQQ close 1100 1045 940.5 1081.58 1000

QID close 1200 1080 864 1123.2 1038.47

NASDAQ 100 % change 10% -5% -10% +15% -7.543%

So why didn't the 2X inverse end up back at 1000 as well? Because the laws of arithmetic don't work that way, as we all learned in sets and numbers:-) The more volatile the movements of the underlying index, the more error there will be in the tracking. If I'd started with a down day rather than an up day, the ultrashort fund would have been playing catch-up all week and ended lower than the NASDAQ 100. Note also that these aren't mutual funds, so the managers aren't going to take a defensive position and sit on the sidelines if it looks like the market is going against them.

I'm very comfortable selling short with the simple inverse (1X) shorts because I'm convinced that the market isn't going to change over to bull mode in a hurry, but I protect myself with stop loss orders. Stop loss orders are even more important with the UltraShort funds or you could lose half your retirement in between brokerage account checks, if you are the once-a-month type. The problem with stop loss orders is deciding where to place them. The UltraShort funds are pretty volatile, I stay away from them myself as being pure gambling, and given the choice between going short (1X) with $30,000 and going short (3X) with $10,000, I'd choose the former, just to remain in touch with reality. Unless you're a day trading in your retirement accounts, working with a stop loss margin of 5% practically amounts to a sell order at the lower price. I usually go with a band of about 10%, and even there, if the underlying market pops 5% over a couple days on news of more Fed intervention, you're going to get sold out at a pretty steep loss. If you buy the basic short funds and think that they aren't tracking the underlying indexes properly, you probably misunderstood the prospectus. For example, the NASDAQ short PSQ and ultrashort QID seek the inverse of the NASDAQ 100 (QQQQ), not the entire NASDAQ index.

I won't be shocked if someday the government decides that selling short should be prescribed from IRA accounts as being "risky". That's typical of the modern interpretation of capitalism meaning that markets should always go up, as opposed to meaning that markets should express the underlying value of assets. Just a month or two ago the regulators made it more difficult to short financial stocks, in the theory that speculators were hastening the deaths of the undercapitalized banks and invest houses. Of course, the regulator never complained when people went long on those stocks, creating a short squeeze and driving the stock prices up. It's like Alan Greenspan said, the current system works to privatize gains and socialize losses. All I know is that if my SEP IRA money had been sitting in regular (long) index funds the past year rather than short funds, my retirement savings would stand about 30% lower than they they do today, and I'd have lost a bit of sleep getting angry about it as well.

Two days after I originally wrote this article the government banned shorting of 799 financial stocks and may get to the rest under congressional pressure. Since the ProShares funds achieve their results with credit default swaps, rather than borrowing shares and shorting stocks the traditional way, it may not matter in the long run. The IRS does not answer questions about using ProShares and other ETFs in retirement accounts, they just tell you to consult a tax advisor.

This guide is in progress, and I welcome your comments, questions and suggestions