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Bearish on Oil? Here Are 3 Inverse Oil ETFs You Should Know About

The price of oil has been extremely volatile in recent years, with per-barrel crude prices climbing as high as triple digits and falling as low as the upper $20s in a short time frame. Many investors in energy stocks have gotten crushed by the plunge in crude since late 2015, and exploration and production companies are still struggling to adapt to less favorable conditions in the energy markets.

Yet investors who want to profit from oil's decline can turn to exchange-traded funds that specialize in providing inverse returns to movements in crude prices. By using one of the inverse oil ETFs listed below, you can see the value of your investment go up when oil falls -- as long as you're prepared to suffer losses when energy prices rebound.

Inverse Oil ETF

Assets Under Management

Expense Ratio

5-Year Average Annual Return

ProShares UltraShort Bloomberg Crude Oil (NYSEMKT: SCO)

$127.7 million

0.95%

12%

PowerShares DB Crude Oil Double Short (NYSEMKT: DTO)

$50.5 million

0.75%

24.9%

United States Short Oil Fund (NYSEMKT: DNO)

$11.3 million

0.75%

13.1%

Data source: Fund providers.

How to profit when oil drops

The way that inverse oil ETFs generally work is to use derivatives to get inverse exposure to the oil market. The United States Short Oil Fund is the simplest of the three funds listed above, with an investment objective of giving investors the inverse of the daily return of the price of West Texas Intermediate light sweet crude. If oil prices fall 1%, then the fund is designed to rise 1% in value, and vice versa. To do so, the fund holds short positions in crude oil futures on the New York Mercantile Exchange, and it keeps its assets in cash for use as margin for those short oil-futures positions.

Each month, the United States Oil Fund rolls over its futures contracts, buying back the near-month contract and selling positions that expire the following month. This can provide added return when the price of the near-month contract is less than that in subsequent months, as is often the case. By avoiding leverage, the United States Oil Fund has generated a solid return in recent years as oil prices have fallen.

Image source: Getty Images.

Making a bigger bet

Other inverse oil ETFs use leverage to attempt to magnify their returns, with varying degrees of success. The most popular ProShares product offers double the inverse of the daily return of Bloomberg's oil index, which includes various crude-oil futures contracts. The fund also invests in swap-derivative contracts to get its leverage. Interestingly, though, the return on the ProShares inverse oil fund has been worse than that of the unleveraged United States Oil Fund. That can reflect disparate performance of the underlying indexes, or it can be a result of the impact of volatility on leveraged funds.

The PowerShares DB Crude Oil Double Short has a similar investment objective, but it has done a much better job of capturing return. That's likely a function of the different way in which the underlying index handles the oil market.

The index is designed to maximize returns when a fund rolls over futures contracts into subsequent months by providing risk-optimized exposure across futures contracts with different expirations. That way, the index can adapt to changes in the markets and turn them to its advantage. The PowerShares oil fund's returns show the success of that strategy, with a total return that's much closer to double that of the unleveraged inverse oil ETF.

Be aware of risk

The one thing investors should note above all is that these funds have produced these returns during a period of extremely rapid declines in oil prices. If the price of crude goes up, then investors have to be prepared for substantial losses, and even flat performance in crude oil could produce losses for funds if expenses and market-related friction take a bite out of total return. Despite their long-term gains, inverse oil ETFs are designed for short-term trades and should be used very carefully for longer-term purposes.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.