- Leverage heightens the price sensitivity of market-maker hedges, taken to protect firm capital required to be put at risk when providing market liquidity for clients.
- Their hedging actions anticipate future price moves in major market indexes, as well as in specific stocks.
- Certain leveraged ETFs have demonstrated clear and reliable forecasts over the past two years, and longer.
Available major market indexes
The principal US stock market indexes referenced by individual and institutional investors are the S&P500, the Dow-Jones 30 Industrials, the Nasdaq100, the Russell 2000, and perhaps to a lesser extent, the S&P600 and S&P400 indexes. The broadest of these, and most widely-used as a general stock price indicator, is the S&P500. The others provide useful insights into market segments such as technology and smaller-sized companies that may attract investors with specialized interests.
All of the above are tracked by Exchange Traded Funds [ETFs] that provide a convenient means of portfolio emphasis for both large institutions and small individual investors alike. Some of the ETFs have structures designed to amplify their price moves in comparison to the daily index price moves by either two or three times.
Peculiarities in the means of accomplishing that leverage distorts that effect over time in the inverse leverage (shorts) ETFs in a pronounced way. But it has little enough effect on the long-leveraged ETFs so that the amplification over weeks and months often has its intended effect, albeit not necessarily in perfect proportions.
Here is an organization of the widely-held and actively-traded ETFs that are tracking the major US market indexes:
We utilize the hedging activities of the market-making [MM] firms that help big-money funds and institutions make adjustments in their billion-dollar portfolios. The scale of the clients' needs often taxes the capacity of markets such that the MMs "facilitate" filling their client's trade orders by adding to the "other side of the trade" with their own capital, temporarily. The risk thus incurred by the MM is offset by price change insurance skillfully engineered in the MM community.
What the parties involved are willing to pay for that insurance, and the way the deal is structured tell just how far all concerned believe the subject's price may get pushed, both to the upside and the downside. Those ranges are plotted in the vertical lines in this picture for ProShares Ultra Pro Russell2000 (NYSEARCA:URTY), the 3x leveraged tracking ETF for the Russell 2000 small-cap index.
(used with permission)
The heavy dot in each vertical price range forecast is the market quote for URTY at the time each daily forecast was made. Most ordinary stock price charts are purely historical, picturing what already has happened. BTF (block trader forecast) charts like this, picture what knowledgeable investment professionals have thought is yet to happen.
The colors in the picture are a function of the proportions of upside and downside price prospects defined by the current market price dot.
This daily-interval picture covers only a half-year. By extracting one day a week, we can in the same display space go back and see how well their thoughts were carried out in the fullness of a wider time of 2 years.
Clearly, the MM expectations ranges have provided a number of useful points of emphasis through the two years for URTY.
This 4-year (full-life) history of every possible 80-day price-change for URTY tells how well the MM community understands this ETF's prospects. The light-blue row reports the annual rate of change, in weekly intervals of up to 16, or 80 market days, starting at each of the 1028 days of available forecasts.
Using the balance between upside and downside prospects each row above the blue row contains only those days with an upside-to-downside of at least that indicated in the Reward-to-Risk column at left, with a count of days in the #Buys column. The magenta #Buys indicates where the current R~R balance is now.
Likewise, the rows below the blue row display the average annual rate of price changes where downside price forecasts exceed upside ones, progressively row by row.
URTY is not the only ETF with these impressive qualities. The stocks in the Dow-Jones 30 are some 40% of the entire market capitalization of the S&P500 index, so they have a natural attraction for big-money investment funds. The MMs are in negotiations daily with hundreds of clients over all of these stocks. So it figures that a 3x leveraged ETF of that index, ProShares UltraPro Dow30 (NYSEARCA:UDOW), might show effects similar to URTY. And it does:
The MM's awareness of their clients' attentions and intentions gets quite graphically depicted over the past two years, and in the past 4 years' table ranking the reward-to-risk differences as well.
In the table below it shows quite strong price gains to the right of that magenta 156 (days) of forecasts like today's, and not shabby returns when held out even beyond the next 3 months of 63 days.
Not much scary appears before market quotes get above the midpoint of the forecast, and there appears to be further to go for that to happen.
So for both huge stocks and small stocks the smart-money outlook sees lots of upside and rather little down. And they seem to have plenty of history on their side. But just because it usually works well that way, remember the statistician that drowned while wading across a pond that was only 3 feet deep on average. (Clue: ODDS of UDOW profitability out at the 3+ months point is above 80 out of 100)