3x Leveraged ETFs and Volatility

Several people on CNBC have talking about how the new 3x ETFs are contributing in a big way to the surges and plunges during the 3 o’clock hour leading up to the close. Has anyone read any articles on this or care to explain? Thanks!

They’re wrong. Explanation over.

Yeah because someone buys a few futures contracts at the close. Like SSO has a total of 3B under management. Yawn.

I was trying to think this through. The 3x ETFs almost certainly use futures to implement 3x leverage, and futures require that someone take the opposite side of the trade. How that spills over into the restnof the market is tough to say. Some people (probably many) will be hedging their existing exposures for whatever reason, and that shouldn’t change prices at all. If Market makers are required to take the other side of the trade, then they might hedge their position by buying/selling an index or the components, and that could move the market in theory. But I don’t think the new 3x ETFs are likely to have sufficient volume to cause the massive gyrations we’re seeing. It’s like saying the an activity that causes a big splash in a swiming pool is somehow going to cause an entire ocean to spill over.

I don’t know but I was long BGZ going into yesterday. Held it over the weekend. Yeah I had a good day :slight_smile:

that was me dude, sorry. fat fingered that last one. i just think the newscasters on cnbc should try to: i) report facts ii) dedicate at least 50% to courney regan’s newsbriefs. iii) go outside and play

Yeah the whole thing seemed a little far-fetched. The way they were describing it was that the “evil” hedge funds, would rush in at 3:45 and buy the 3x leveraged ETFs in whichever direction the market was going that day. The massive last minute buying would overwhelm the market and new ETFs would have to be created quickly before the close causing them to buy up huge amounts of the underlying securities to create the ETFs. In theory this would move the prices wildly up for long or down for short.

If that was the theory why would a hedge fund use a retail investor toy to do it? Just go buy S&P futures and let the arbitrage machines do the equity buying.

I dont know - maybe the HF’s have rules against using futures - whereas they could technically be “long” an ultrashort and still be in compliance with their investment policy…

The volume is still comparably low on those etfs…i dont think they are moving the market

A more credible source is talking about this now. Here’s a short excerpt. Just curious if anyone sees any merit in the argument when described this way… Are ETFs Driving Late-Day Turns? http://online.wsj.com/article/SB122929670229805137.html (excerpt) But even with that kind of volume, how could these ETFs drive a market where billions of shares change hands every day? The answer, many say, has to do with the hedging by dealers who make markets in the funds and traders who pile on to make a profit. Unlike traditional ETFs, which are backed by baskets of individual stocks, leveraged ETF shares are usually created by using swaps or options. Brokers who sell the sponsors these funds must then either buy or sell the underlying shares covered by the ETF at the end of the day. And just as they magnify returns for investors, the amounts needed to hedge are multiplied. What’s more, both the levered short and long ETFs create trading in the same direction. Here’s how: Take a bull market ETF designed to deliver twice the returns when stocks move higher. Starting with a base value of $100 per share, a broker who sells the ETF to a client will have an exposure to the market of $200. If the market falls 10%, the value of the ETF falls 20% to $80 and the broker’s exposure falls to $180 once the market’s move is factored in. To square the books, the broker sells $20 of the underlying stocks at the end of the day. Then consider $100 of a double-leveraged bear market fund, which leaves a dealer with $200 worth of short exposure. If the market falls 10%, the fund rises in value by 20% to $120. The dealer’s short exposure is now $180 once the market’s move is factored in. As a result, the dealer must sell $60 to get back in line. As the market grew more volatile in September, Wall Street proprietary trading desks began piling onto the back of the trade knowing that the end-of-day ETF-related buying or selling was on its way. If the market was falling, they would buy a short ETF and short the stocks or the market some other way. If the market was rallying, they would buy a bull fund and go long.

Hmmm… OK, I see the point about a 3x fund having the effect of a fund with 3x the notional value. There may also be end-of-day liquidity issues that magnify stuff. However, I still think the market is far far larger than even 3x the notional of these funds + a liquidity penalty. There may be an effect, but I still don’t think it accounts for these enormous swings at the end of the day. If SSO has 3B in notional value, then 2x that would be 6B (since SSO is a double fund) and 3x that would be 9B (if it were a triple fund). Then if you had a 5% S&P swing at end of day, that would mean about 450MM would be changing hands. That’s on a big day. Seems like a lot of money to me, but probably not huge compared to the total market volume. Anyone have data on the average daily volume, and perhaps the average volume for the last hour of the day?

Does that article seem remotely reasonable to anyone? Short ETF’s and long ETF’s create trading in the same direction when markets move? Does any dynamic hedging work that way? There are at least 10 mistakes in that small excerpt and that guy has absolutely not a shred of a wisp of a faint clue.

Definitely agree that short/long ETFs cannot explain the large cap volatility in the last hour of trading recently. Sometimes a hypothesis for ETF’s impact on small caps can be made: like on 6/30/08 the Russell 2000 ETF (IWM) was about 300% short. This short was covered over the next month or so and the number of shares of the ETF issued more than doubled. You could say that this bid up the prices small caps, especially the most illiquid stocks.

Someone wants to buy an ETF because they can’t trade in futures markets. So they go out to buy an ETF. The most likely thing to happen is they buy it from someone else and no new anything is created or moved. The next most likely thing is that the position is hedged in the derivatives markets, e.g., the futures market. There is just no need for any further hedging past that point.

I agree Joey, it is typically unlikely it would affect anything. The example I gave was just a case where it “could” affect stock prices. I did a little work on this some time ago. The numbers I used in the example are accurate: shares out of IWM went from about 100 mil to 200mil in 3Q08 and short interest went from 300 mil to a little below 200 mil. Creation could have an effect on the smallest stocks in the index.

JoeyDVivre Wrote: ------------------------------------------------------- > Does that article seem remotely reasonable to > anyone? Short ETF’s and long ETF’s create trading > in the same direction when markets move? Does any > dynamic hedging work that way? There are at least > 10 mistakes in that small excerpt and that guy has > absolutely not a shred of a wisp of a faint clue. I can’t wrap my head around this concept and I’d have to say he’s right from my understanding unless I can be told otherwise. Disregarding futures trading and getting to the barebones of it all, the way I see it is that if an investor puts $100 equity into a 2x fund, he has $200 exposure, meaning $100 in debt. If the market goes down 10% and he’s holding a bull fund, $20 in shares are sold to match the debt portion to the $80 left in equity. If he’s holding the bear fund, equity goes up $20 and debt exposure must increase by $20 to allow for 2x leverage, meaning the etf co must short $20 more in stock. Even if they do create exposure in the same direction, some of the end of day movements have lead to market gains from 4% to 7% or -3% to -6% and would often be reversed heavily in the following day. I don’t see where these HFs would make their money if they are just pushing the market further at the end of the day, soon to be reversed back? Are they pushing at 3:45 and covering the trade at 3:58? This is the only way I would see them make any dough, and maybe this is the reason why there are often ‘kickbacks’ in the following day after large loss or gain days as the etfs have to make trades they couldn’t complete by close on the previous day due to late covering by HFs.

Hedge funds don’t trade these silly ETF’s. These are retail investor nonsense. They are just packaged swaps. HF’s trade real swaps.

Why would the traders/mm’s wait till the end of the day to hedge their exposure though? Wouldn’t they do so throughout the day to get back in line?

JoeyDVivre Wrote: ------------------------------------------------------- > Does that article seem remotely reasonable to > anyone? Short ETF’s and long ETF’s create trading > in the same direction when markets move? Does any > dynamic hedging work that way? There are at least > 10 mistakes in that small excerpt and that guy has > absolutely not a shred of a wisp of a faint clue. This definitely occurs. IF MARKET IS DOWN YOU ARE A SELLER IN THE LONG AND SHORT FUNDS, IF MARKET UP BUYER IN LONG AND SHORT FUND. If the market is up on the day, your leveraged long fund will have to buy exposure to maintain its 2x leverage. Your leverage short position will have to buy back exposure to maintain its 2x short position. Example: 2x long AUM = 100 Fund exposure = 200 Market Goes up 5%: AUM now 100 + 5% X 200 = 110 Fund Exposure now 210 Leverage = 210/110 = 1.9X Need to buy 10 of exposure Example: 2x Short AUM = 100 Exposure = -200 Market Goes up 5% AUM now 100 + 5% x -200 = 90 Fund Exposure now -190 = -200 +10 Leverage = -190/90 = -2.111 Need to buy back 10 of exposure to get -180/90 = -2x