Subtitle: Intraday Correlations between ProShares ETFs and Broad Market Indices
On June 30, 2010, the SEC announced its intention to expand the circuit breaker pilot program to many more stocks and, for the first time, ETFs. Public comments have expressed concern that, when applied to ETFs, circuit breakers may themselves create market disruptions. If a circuit breaker is triggered, whether appropriately or erroneously, for a widely-traded ETF, HFT firms major market participants may pause trading and deprive the market of liquidity when it is most needed. Once an ETF selected for the pilot program triggers a circuit breaker, firms which trade the basket of underlying stocks may also step away for five minutes until trading in the ETF resumes. In such a scenario, the impact on the liquidity of stocks underlying a halted ETF will demonstrate whether the circuit breaker program meets its objectives in practice.
Not all ETFs have been selected for the circuit breaker pilot program. NYSE Euronext compiled a list of 344 ETFs ("piloted ETFs"), as reported by Index Universe, utilizing a volume cutoff:
"NYSE Euronext, the parent company of the New York Stock Exchange, developed the list of 344 ETFs in consultation with other major exchanges and the Financial Industry Regulatory Authority.
"NYSE Euronext winnowed down the universe of U.S. ETFs by excluding products whose average daily trade volume was less than $2 million worth of shares, it said in a press release."
This criteria for selected ETFs produces some interesting and potential trading scenarios. For example, SPY and IVV, two ETF's which track the S&P 500, are included in the proposed expansion of the circuit breaker program. Therefore, if one of these two ETFs triggers a circuit breaker, will the market simply move to trade the other ETF until five minutes passes? What are the odds that both SPY and IVV will simulateously trigger circuit breakers? (This is not a rhetorical question.)
Given the complex trading relationships between an ETF and its underlying stocks, concerns about market disruption resulting from a circuit breaker are difficult to prove in theory and potentially difficult to quantify. A further review of the list of ETFs proposed for the circuit breaker pilot program reveals another interesting scenario: if a broad-market ETF triggers a circuit breaker, can traders utilize leveraged versions of the ETF to continue trading through the duration of the circuit breaker?
To address that possibility, we start with a summary of ETFs which may serve as substitutes (or proxies) for three broad market ETFs: SPY, QQQQ, and IWM.
First a definition of the term "leverage ratio" as utilized in this analysis. To take an example, the ProShares Ultra S&P 500 (NYSEARCA:SSO) has a stated objective of going up or down twice as much as the S&P 500 index, on an intraday basis. Hence, the stated target leverage ratio for SSO is +2. Conversely, the stated target leverage ratio for ProShares UltraShort S&P 500 (NYSEARCA:SDS) is -2 because SDS moves in the opposite direction to the S&P 500. By looking at the returns of leveraged long/short ETFs over 5-minute intervals during 2010 Q2, we compare their returns to the underlying index by utilizing linear regression analysis. These regressions are constrained to have a zero alpha (zero intercept) so that the resulting beta (slope) provides a useful (albeit not perfect) measure of the leverage ratio. Each regression compares a single ETF to its underlying index, ignoring any 5-minute intervals when such ETF did not trade. Otherwise, volume has no impact on the regressions. By constraining the alpha to zero, the following graphs need to display only the slope (termed the "observed leverage ratio").
The closer an ETF trades to its stated target leverage ratio, the better such ETF may serve as a proxy if another related ETF triggers a circuit breaker. How well might various leveraged long/short ETFs of the S&P 500 index serve as proxies to SPY, IVV, or SH? The following graph shows the consistency of the leverage ratio for every trading day furing 2010 Q2.
On a daily basis, the leveraged ETFs appear to trade according to their stated target leverage ratios. As the target level rises to 2x and 3x, the observed leverage ratio for both long and short ETFs exhibits greater variability around the target level. Perhaps the efficiency of instruments used to gain leverage suffers as leverage rises. Liquidity might also play a role. Leveraged ETFs typically have lower trading volume than their corresponding long unleveraged ETFs (discussed in detail further below).
Can one draw the same conclusion by looking at the observed leverage ratio over intraday 5-minute intervals? In this graph, the leverage ratio is computed through a linear regression utilizing all trading days during 2010 Q2 but for a specific 5-minute interval during each trading day.
Switching from a time-based perspective, the next graph shows the observed leverage ratio according to the return in the underlying index during 5-minute intervals.
All ETFs based on the S&P 500 traded close to their stated target leverage ratios as long as the underlying index did not rise or fall more than 0.40% within any 5-minute interval. As the underlying index became more volatile, the observed leverage ratio tended to shrink. Note that as the magnitude of change increases, the number of historical data samples drops, which may in turn reduce the regression quality and increase the standard error of the slope (beta).
In the same manner, we can determine how well various leveraged long/short ETFs of the NASDAQ 100 index served as proxies to QQQQ or PSQ. The following two graphs plot the observed leverage ratio over time, first daily followed by intraday, and roughly follow the patterns seen in the graphs for the S&P 500. For the ProShares triple-leveraged ETFs, SQQQ and TQQQ, the observed leverage ratios deviated from the stated target levels more so than for the corresponding ProShares ETFs tracking the S&P 500 .
According to the return in the Russell 2000 during 5-minute intervals, the following graph shows that the observed leverage ratios tracked (and many times exceeded) the stated target levels most of the time. Only when the Russell 2000 index rose or fell by more than 0.50% did the observed leverage ratio decline significantly.
The following three graphs compare the daily volume of the ETFs listed above (except for IVV). When selecting ETFs to include in the pilot program, the SEC focused on the highest-volume ETFs for the three broad-market indices. In addition, the corresponding unleveraged inverse ETFs had respectable volumes but lower than some of their leveraged counterparts. (Note the log scale for the vertical axis.)
In conclusion, the above analysis demonstrates some key aspects of leveraged ETFs which require careful consideration during normal and volatile periods of intraday trading.
1. As intraday (5-minute interval) price volatility of an underlying index increases, the observed leverage ratio drops significantly below stated levels. If an underlying index rises or drops by more then 0.50% in a 5-minute interval, then the leveraged ETFs may not trade at a predictable correlation to the undering index within the same interval.Once the proposed ETFs are rolled out into the circuit breaker pilot program, leveraged ETFs will be put to a potentially new test . How might leveraged ETFs behave empirically should a related ETF trigger its circuit breaker?
2. As intraday price volatility of an underlying index increases, the corresponding volume also increases, confirming that ETFs are popular among traders who seek to rapidly gain market exposure or hedge existing positions. Both leveraged and unleveraged ETFs exhibit the same pattern of trading volume, which demonstrates that a leveraged ETF may be a viable proxy for an unleveraged ETF which has triggered its circuit breaker.
3. Both the NYSE and SEC appear to have postponed determining how leveraged ETFs may be included in the circuit breaker program. Most likely, the embedded leverage of such ETFs increases their chance of triggering a circuit breaker at times when other similar ETFs may trade inside their trigger levels. Such a potential scenario is further complicated by past behavior of observed leverage ratios, as shown above. (Currently, the SEC is not granting exemptive relief to ETFs which request to make significant investments in derivatives.)
4. The SEC is already concerned with the performance of leveraged ETFs, specifically due to their daily resets (which should not be pertinent to intraday leverage ratios). Might the exercise of identifying circuit breaker trigger levels create further scrutiny on a product where FINRA states "typically are not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets"?
Disclosure: No positions
Disclosure: No Positions