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Vikram Saxena
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Vikram is an electrical engineer by training and has held a variety of roles spanning multiple industries. He started his career in the semiconductor industry in the Silicon Valley, before moving to a proprietary trading desk at a bulge bracket investment bank in New York. Vikram has also... More
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  • Thoughts on Technical Analysis on Leveraged ETF

    Leveraged ETFs like the SKF, UYG, SRS, FAS, FAZ, TBT, DIG and DUG have become very popular trading vehicles.There has been some debate among traders on how to use technical analysis on leveraged ETFs. Some traders argue that technical analysis works the same way on the leveraged ETFs as it does on the non-leveraged ETFs. Others argue that the unleveraged ETF or index corresponding to the leveraged ETF is the better tool.

    In this article I will review some topics of relevance when using technical analysis on leveraged ETFs. Henceforth, I will refer to leveraged ETFs as LETF and the underlying ETF or index as the underlying instrument, UI.

    Characteristics of Leveraged ETFs

    When viewing a LETF I first look at the following characteristics:

    1.Duration of compounding: Until now almost all LETFs compound daily; i.e. they aim to achieve the leveraged return based on the previous day’s closing price with the base being reset every day. There is some talk of LETFs which compound on longer durations in the pipe-line; however in this article I will assume daily compounding.

    2.The amount of leverage: Most LETFs offer 2x or 3x leverage

    3.Trading Volume versus the Underlying Instrument (Follow vs. Lead): In some cases the trading volume on LETFs is not big enough to affect the behavior of the UI; the LETF follows the UI. In some other cases there is speculation that LETFs have become the trading instrument of choice and their price action affects the UI; the LETF leads the UI.

    Price Behavior of LETFs vs. the UI: Path Dependency of Results

    The fundamental reason behind the debate on technical analysis of LETFs is the fact that LETF returns are path-dependent. In a window covering many days, the final value of the LETF will be affected not only by the absolute movement in the price of the UI, but also by the path taken by the UI to reach that value. So a roundtrip in price of the UI will not only, not translate to a round-trip on the LETF, but the value for the FETF will be different for different price-paths.

    For example, suppose a 2x LETF is trading at $100, as it the UI. If the UI moves up by 2% to 102 by the close of the day, the LETF will close at $104. If on the next day the UI moves down to $100, the LETF will close at $99.9216. However, if the price of the UI first went down to $98 and then back to $100, the LETF will close at $96 first, and at $99.9194 next.

    Non-Trending Markets: Volatility Decay

    The skew between LETFs and UI returns leads to what some call the volatility decay on LETFs when the markets are not trending but trading in a range. The roundtrip example above illustrated that. When the process continues over a larger time-period, this decay accumulates.

    In the above example, if the UI completed three roundtrips (100->101->100), the LETF’s value will fall to 99.94. If the size of the oscillations is large, the effect becomes even worse. So three roundtrips to 102 (100->102->100) will reduce the LETFs value to 99.765, a 23bp loss in just six days. The effect is even more pronounced in LETFs with 3x leverage which will have a value of 99.296, a loss of 70bp after three round-trips. The chart below shows the decay over six round-trips.

    Path Dependence: When is it Relevant?

    The path dependence of LETFs becomes relevant when the technique you are using relies on absolute price levels. Support-Resistance Levels, Gap Analysis, price targets based on patterns, Fibonacci retracements and extension levels, all rely on absolute price values. The behavior here gets significantly altered.

    On the other hand, if the technique you are using relies on relative price movements over a given time-frame the path-dependence of the LETF becomes less important. This is typically true of most price-patterns and oscillators among others. Note that the type of pattern observed may change; or the settings of the oscillator and their interpretation will change from the LETF to the UI.

    In the next sections, I will address some specific topics of interest.

    Time Window of Analysis: Intra-Day versus Multi-Day

    If the TA is being performed exclusively within the time-window between the reset of the compounding events (i.e. intra-day), then almost all indicators, including those based on absolute price levels will work. Intra-day support-resistance, trend-lines, chart-patterns on LETF will provide the same information as their counterparts on the UI.

    Note that calculated indicators (e.g. oscillators) will have to start with a clean slate at the start of the reset window to get a pure and true result; in practice this level of absolute perfection may not be necessary for the trader to make a decision.

    Volatility Decay and Trend Lines

    Volatility decay means is that the chart patterns observed will vary between LETF and the UI. The LETF has an inherent negative bias and the price will shift downwards. As a result during periods of consolidation the horizontal support and resistance lines get converted into downward trend lines. In the example earlier, where the UI makes multiple round-trips to the same starting price, the UI will form a horizontal ledge pattern, but the LETF will form a descending channel.

    Adjusting Technical Price Levels

    In the above example, a trader looking for a breakout will have to consider different price-points. On the UI a break above the upside resistance (102) will constitute a buy point. In the case of the descending channel, the breakout buy point is not that obvious. Is it the highest point of the channel or a break above the previous swing high, prior to the break above the channel?

    Volatility Decay and Gaps

    Many traders consider price gaps in charts as strong signals, and use the price levels of the gap as key trading points. Due to the decay associated with the LETF, a downside-gap fill on an UI will often not translate into a gap fill on the LETF, since the LETF would still not have recovered to that level. LETF may show an upside-gap fill simply due to volatility decay, when the UI is still trading above the upper side of the gap.

    This phenomenon is very well illustrated by comparing the TBT the Ultra-Short Long Bond fund, and the Yield of the 30 Year Bond (TYX). These are good a pair since the price of the long bond varies inversely with its yield. Further the bond market is huge and technical trading in bond ETFs is unlikely to have a meaningful impact on the bond yields.

    The TYX gapped down on multiple occasions in late November of 2008. These gaps also appeared in the TBT. The TYX filled the gaps in late April and early May. However, even after the massive rally in TBT this week, it still has not filled all the gaps. TYX though is now at a much higher level.

    During the period between February and mid April of 2009, the TYX were range bound and oscillated in a flat channel. During the same period the TBT traded in a downward sloping channel as the volatility decay reduced its value. Any trading decisions based on gaps on the TBT would have been against the spirit of gap analysis.

    The Cart before the Horse Hypothesis

    There is some talk in the media about how in certain sectors, trading in LETFS is having a significant impact on price movements. If the trading in the LETF becomes the primary driver of price movements, then pure technical analysis on the LETF may become significant. However, most of these hypotheses are primarily based on intra-day price movements which make the issue moot.

    So Does TA Work on LETFs?

    Without doubt, there is merit to chart reading and technical analysis on LETFs. However, the interpretation of these charts has to be adapted to account for the specific peculiarities introduced by the volatility decay inherent in their structure.

    Disclosure: Vikram actively trades many of the ETFs mentioned in this article.

    May 29 11:01 PM | Link | Comment!
  • Thursday Roundup: Bond Market Leads Equities

    The financial markets had a relatively sedate day with the action in the bond markets driving equities. The 7yr Treasury auction was met with reasonable demand which had a calming effect on the bond market which finally got a bid. This helped the equity markets finish positive for the day. The energy sector out performed today with a greater than expected draw-down in oil inventories sparking another rally in oil and oil related equities.

    Treasury Market Recovers

    The treasury markets were volatile today, selling off before the auction and then recovering after the auction to finish strong. One metric I follow at the long end is the difference between the 30yr and the 10yr yields. This spread narrowed today, closing below its 50 Day SMA for the first time since early January. The yield on the 30 year has a strong postive correlation with this spread. I presume the 4.5%+ yield on the 30yr bond is attracting buying interest, now that the technical factors associated with the spike in yields have abated.


    Often the most complex market behavior has very simple explanations. The recovery in Treasuries after the bond auction, could simply be attributed to the fact that the Treasury is done selling for this month; and the next auction is going to be in the second week of June, almost a life-time in the current markets. With the overhang of new supply not present, bonds were bid today.

    Economic News: Continues to Point to Improvement

    The equity markets have some good economic news to cheer. There are clear signs now that the economy is gradually bottoming out. The new Jobless Claim number came better than expected, while continuing claims continue to go higher. The Jobless Claim number seems to have topped out in the mid-600K and seems to be declining gradually. This job-loss number is a co-incident indicator; it hits its top when the economy hits bottom.

    On the other hand the news from the housing market continues to be dismal, with almost 12% of all home mortgages delinquent. Durable Goods orders came in higher than expected in April but were revised downwards for March.

    The GDP number tomorrow is going to be important in setting a tone for the market. There are some expectations that last quarter numbers may be revised up.

    My Portfolio

    I continued to day-trade today, using the action in the bond market to guide my equity futures trades. The TLT acted as a leading indicator for the price-action in equities for most of the day. I added to my TLT position in the pre-auction sell-off. The treasuries are getting a bid and I expect a 3% return over the next few days.

    I was a bit pre-mature in establishing my bearish put spread on the USO; it has rallied about 2% from my entry point. However, I am not particularly concerned since this is a spread which expires July. It is quite reasonable to expect a pull-back to the $60 level in the front month crude contract over the next two months. There is a huge overhang of excess supply parked in tankers anchored off-shore which the market is ignoring. Like last summer, the price of oil is being driven up by the falling dollar trade, where investors seek haven in commodities. However, the economic environment we are in is dramatically different from last year, and I believe that the speculative excess in the oil markets is not sustainable.

    Market Outlook: 200 Day SMA Looms

    The S&P500 is now within 24 points of its 200 Day SMA. I expect the market to test that level soon. After a rally of such a magnitude, it would be highly unlikely for the market to come so close to the 200Day SMA but not touch it. Perhaps a bullish GDP report tomorrow will provide the ammunition for the market to make that charge.

    May 28 9:44 PM | Link | Comment!
  • Monday Roundup: Little Kim no Match for American Consumers

    The equity markets reversed course today in another dramatic session. North Korea shocked the world (at least according to the head-lines) by testing a nuclear device which actually worked. This lead a flight to safety in the overnight market with the US Dollar getting a strong bid and with the EUR-USD trading as low as 1.386 down from its close above 1.4. The equity markets gapped-down open but continued to rally up from the open.

    Consumer Confidence Lights a Fire

    The initial rally in the equity markets was not unexpected. The markets had sold off hard into the close Friday as traders did not feel comfortable holding long positions over the long weekend. The gap-down open gave traders an opportunity to re-initiate the long positions.

    However what lit the spark was the biggest gain consumer confidence since 2003; it came in at 59.4, well above the consensus of 42.6. The market ignored the worse than expected Case-Shiller Home Price Index numbers, and of course Kim Jong-Il’s nuclear test.

    Underneath the Consumer Confidence Numbers

    The consumer confidence was led up by its future expectation’s component, with the expectation measure rising to 72.3, the highest since December 2007, while the gauge for current conditions was at 28.9, higher from last month’s reading of 25.5, but a far cry from future expectations.

    The divergence between the two components of the consumer confidence number, mirror the equity markets very well. Though current conditions are nothing to write home about, the expectations for the future are driving the market higher. However, the risk to these green shoots remains high.

    The yields on long term treasuries continued to rise today. The reduction in mortgage payments is a key pillar of the Fed’s strategy for recapitalizing the American consumer. The expectations are that lower mortgage servicing burden, will allow the consumer to spend even under times of reduced credit availability. However, that experiment is likely to fail if yields continue to rise, since mortgage spreads are near historic lows and any rise in treasury yields will affect the mortgage rates.

    Risk Tolerance Returns

    The equity markets were led by the small cap Russell2000 and the technology heavy Nasdaq100. The longer dated treasuries were sold, while the US Dollar lost most of its earlier gains, closing almost unchanged.

    This was in a sharp contrast from last week, when equities were being sold, even when the US Dollar was collapsing against. The positive correlation between the Euro and US Equity market returned today, perhaps indicating a more subtle approach to selling US based assets, compared to the indiscriminate selling of the previous week.

    My Portfolio

    I continued to stay primarily in cash and day-trade. I was able to close out my short Euro positions at a profit, while I continue to hold the bearish put spread on the TBT, perhaps in the vain hope that the long bond yields will pull back to allow the green shoots to grow.

    Tomorrow’s Outlook: 200 Day Moving Average

    The holiday shortened weeks typically have a bullish bias. The market was oversold coming into the open today and was bought right from the get-go. Typically, the day after a strong trend-up day also has a bullish bias, especially at the open. This is primarily due to trapped shorts that capitulate the day after the trend-up day has shredded their position.

    I do not expect another ripping day either after such a strong rise. We are likely to remain range-bound tomorrow, unless of course the existing home sales data surprises to trigger another rally.

    The other big factor affecting the market is the looming presence of the 200 Day Moving Average of the SPX at 934.36, well in the striking distance from today’s close of 910.33. A positive catalyst will send the SPX to this critical level.

    What happens at that level is going to be an important factor in determining where this market goes. If we break through this level on a convincing basis, it is likely that the SPX will hit 1000 or even higher. There is also the chance that the market will sell-off after it hits the 200 Day SMA, and start the long awaited, but still nowhere to be seen, correction.

    May 26 6:06 PM | Link | Comment!
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