Are you impressed by folks that can make themselves a $ million (or more) a year? For many years in a row?
Would you be willing to bet alongside them if their bets pay off 9 times out of every 10?
When their average wins are twice as large as the losses, so they have 20 times as much gain as loss?
Even if you don't bet, would you be inclined to believe them if they told you what they believe will happen to the market? In a specific period of time?
The folks in question are the market-makers [MMs] active in helping big-money hedge funds, mutual funds, and other institutional portfolio managers adjust their bets on the Dow Jones 30 Industrials market index every day.
The easy way for their clients to make those adjustments is by buying and selling the Exchange Traded Fund SPDR Dow Jones Industrial Average (DIA). About $1½ Billion of DIA was traded today. The MMs help them do it, in big chunks, averaging way more than $1 million a ticket.
Thousands of DIA trades are made each day, and the MMs see how interests build up, or flee in fear. It's all reflected in what they call the "order flow." Changes can be gradual or abrupt, tiny in amount or scary in scale of price changes.
The MMs have to put firm capital at risk temporarily to play in this game, and they hate risk, hate losing, even losing an ante to play a hand. So they protect themselves with hedge transactions in related securities that provide profits equivalent to losses that would occur if prices go too far in one way or the other, where their capital is exposed.
It can get very complicated, and dangerous for the inexperienced, so don't try it at home. Instead, add what they know to what you know.
When they choose to bet their own capital -- rather than the firm's, or the clients' -- instead of using the DIA, they look to do far better, with an ETF that tracks the Dow Jones Industrials but leverages up the price changes by an intended factor of 3x -- ProShares UltraPro Dow30 (UDOW). And they often play their game by using options, rather than the ETF. So that makes it even more complicated.
But it provides a very valuable insight into just how far they think UDOW's price is likely to travel, and in what period of time. We know how to translate their bet structures into specific forecasts of both higher and lower prices believed likely, and have been doing it in real time for several years. Here is how their notions of what lies ahead for UDOW prices have evolved over the past six months:
(used with permission)
Each vertical line here is a daily forecast, split into upside and downside prospects by the (heavy dot) contemporary closing market quote of the day. Forecasts heavy in downside exposure may appear in yellow, and those mostly offering upside opportunity may be in green.
While the inferences may seem obvious when viewed after the fact, we regularly test these forecasts "ex-ante," before the fact, to see how well the MMs forecasts hold up in real life. The test is simple: Top of the forecast range is a sell target, and holding patience is limited to 3 months (63 market days). A position entry price (from the end of day after the forecast date) is closed out at the first close price equal to or greater than the target, or at the end of the patience period. Gains are averaged geometrically, and converted to annual rates to aid payoff comparisons. Every instance of a prior balance between upside and downside at least as attractive as the present is included in the average.
Here is UDOW's scorecard on those prior test experiences:
The previously described sell target currently of $90.18 is 7.8% above the current UDOW price of $83.64. The Range Index, a metric which tells what percent of the full forecast range is below the current market quote, is now at 4 -- very minimal downside. The forecast proportions between upside and downside is most encouraging, but real life experience helps hold things in balance. Getting to the sell target rarely happens in a straight-up line. There are usually price pull-backs that must be endured and in the case of UDOW a -10% Drawdown Exposure tells how bad it can get at its worst.
There were 84 market days with a Range Index as good as the present in the 3½ years that this ETF has been in existence, or almost 10% of the time. That is enough past history to help judge how accurate the MMs' current forecast may be in looking to the future.
In our test some 9 out of every 10 instances were profitable (odds of 90 in 100) and prior similar forecasts came to fruition in an average of 40 market days, or 8 weeks, just less than two months. An ability to reinvest that frequently at an average gain (including the losses) of +14.7% would produce an annual rate of 136%.
There is no guarantee that the future will play out in the way it has in the past, or that the MM community at large has acquired some previously avoided mass delusion as to the probable state of coming investor behavior. But there may be some comfort in seeing how MM expectations have traveled across the past two years:
(used with permission)
This picture is simply a once-a-week extraction of live daily forecasts to create a two-year look at the typical behavior of MM expectations over time. In UDOW we have chosen an illustration where MMs appear to have considerable capabilities. In our population of over 2,000 stocks, ETFs, indexes and REITs, there are others of similar value, and still others where your notions or my unaided ones might be more competitive. We have chosen from among the better ones so as to not waste your time or your capital commitments with less productive possibilities, of which there are many.
A 3x leveraged tracker of the Dow Jones 30 Industrials bears an outlook of more than 7½%, so the DIA may well have a 2½% upside in the next 3-4 months, with little likelihood of appreciable downside.
Additional Disclosure: The author has an investment interest in the website blockdesk.com which, while not yet open to the public, is in conversion from being a delivery medium of information to institutional investors to a new life of providing similar help to do-it-yourself investors. Both brief and extended-time subscriptions for single or multiple issue inquiries should be at quite reasonable and manageable costs for individuals. Announcement of its opening is hoped for in the 4th quarter of this year.