Leveraged ETFs Might Be the Cause of Late Day Trading Moves

There has been a lot of discussion lately regarding the surge in volatile late-day trading that has occurred since the summer sell-off and fall credit-crisis began to unfold. In November alone, an average of 26.2 percent of trading volume in S&P 500 (SPY) stocks took place in the final hour of trading, with 17.1 percent of the trading occurring in the final 30 minutes (see WSJ article).

Furthermore, for eight of the ten worst days for the S&P 500 since September 1st of this year, 29 percent or more of the move took place in the final hour of trading, with three instances in which over half of the market decline occurred during the last hour. Much of the blame for the late day sell-offs has been assigned to hedge fund redemption selling, or simply nervous traders unwilling to hold positions overnight. A possible new culprit may be ETFs, in particular, leveraged ETFs.

Leveraged ETFs, now numbering over 100 in total (see lists here and here), have recently become popular since they allow market participants to take 2X and 3X positions on popular stock and sector indexes. Many of the leverage ETFs utilize swaps and options to achieve their leverage ratios. Not surprisingly, when the linked index or sector falls, corresponding stocks in the ETF have to be sold at a two to three times greater rate, increasing the moves in the indexes. In fact, the trend has become so predictable that many proprietary trading desks actively trade the levered ETFs toward the end of trading days with large moves, knowing that increased buying or selling is on its way.

While the VIX has been coming down over the last few weeks, it is still at elevated levels, indicating that the next big daily move up or down is likely to be capped off with an equally impressive last hour move, generated in part by momentum investors taking a position in leveraged ETFs. For once, the market (myself included) has someone else to blame besides the hedge funds for late day trading volatility.

Comments

[sceptical:]

Perhaps it is hedgies arbitraging ETF's v. mutual funds (which trade on closing prices)

2008 Dec 16 09:39 AM

[Fairway Jack:]

Please explain precisely how we can read the VIX to predict the next big daily move up or down...so as to take advantage of the big moves in the last hour of the trading day. Thx.

2008 Dec 16 11:35 AM

[sbenard:]

I've noticed this same phenomenon, and like the large trading desks, I have been taking advantage of the increased volatility at the end of the day. It's a good strategy. However, volatility is a double-edged sword, and if caught on the wrong side of the trade, can be costly. I keep very tight stops at these hours of the day, and I get out very quickly once the momentum fades.

2008 Dec 16 01:28 PM

[Hodarius:]

Leveraged ETFs don't buy or sell any actual stocks, and therefore don't affect stock prices. Leveraged ETFs buy and sell derivatives (options, swaps) that are *tied* to stock prices, and therefore will affect prices of options - but not the stocks that the options are tied to.

2008 Dec 16 02:29 PM

[dfx:]

correct. they buy (AKAIK) warrants and then ... some other firms have to go and execute the actual trades. I don't understand when or if stocks get transferred to ownership by the ETF. so its like a time-blur effect : we can say that the ETFs don't buy/sell the market, but they do so indirectly. heavy buying forces heavy buying thru the executing parties.

and that is part of the confusion of modern day casinos ... erm...sorry...finance.

I'm trying to figure out in greater depth how these ETFs actually execute and nobody ever answers me. because they don't know.

this is really important and we need to get to the bottom of it.





On Dec 16 02:29 PM Hodarius wrote:

> Leveraged ETFs don't buy or sell any actual stocks, and therefore
> don't affect stock prices. Leveraged ETFs buy and sell derivatives
> (options, swaps) that are *tied* to stock prices, and therefore will
> affect prices of options - but not the stocks that the options are
> tied to.

2008 Dec 16 07:12 PM

[squark62:]

see dave fry's response to this theory. it's whoey.

2008 Dec 16 11:27 PM

[Daniel Moser:]

This late in the day momentum argument is structurally sound. The leveraged ETF's are mandated to maintain a 2:1 debt to equity ratio or in some cases even a 3:1. When the general market gets extremely volatile it throws their debt to equities ratio off drastically on a daily basis, thus they have to go out into the market place and buy or sell their underlying securities to rebalance their debt to equity. Remember they don't care where the market is going...there job is to be 2:1 Long or Short their underlying index.

Now, why would this occur at the end of the trading day? Easy...if your job was to maintain a 2:1 debt to equity position, you would never rebalance at 12:00 during the day. You would have no idea what your portfolio would look like at 3:00. Thus, they have to wait until the end of the day so that they actually accomplish their mandate.

Also the argument that they don't actually buy or sell underlying stock is fundamentally not true. You can easily see their top 10 holdings in many of them. Think about it...how do you maintain a 2:1 leveraged ratio on some set index? You issue a bunch of debt and buy all the underlying securities. When your debt to equity gets out of whack because of the change in stocks prices, it is by far easier to buy or sell equities than it is to alter your debt structure. If for some reason I am wrong about this argument, my next point would be that somewhere with in mere seconds a market maker is out there shorting or buying stocks so that they are hedged thus somebody is trading the underlying stocks.

I don't really believe the VIX has anything to do with this at all except to the extent it can predict volatility in the coming month. This is all about the mandates of the ETF's that force momemtum to beget more momentum. It takes violent market moves to force these ETF's to rebalance in big ways which just makes the market move even further. If the actual volatility dies down...their rebalancing won't be so disruptive.

2008 Dec 17 06:27 PM

[Amey:]

still trying to understand how these returns are made and make people money if there is no real substance behind them.

Sep 25 12:35 PM