Friday, April 24, 2009

Leveraged ETFs: Making Volatility More Volatile?

Here we see the five-minute ES futures for Friday, plotted with a 20-period volume-weighted moving average. Note how volume and volatility picked up dramatically around the 13:00 PM hour, with the announcement of bank stress test details. Twice in the day, we saw buying interest peter out at new highs for the day, followed by violent selling and equally herdlike buying. This created volatile oscillation around the VWAP, trapping buyers and sellers alike.

We've been seeing an increasing amount of this herdlike intraday behavior, especially in afternoon stock market trading. This is playing havoc on short-term traders and also longer-term swing traders, who find good positions quickly going bad. There is speculation that leveraged ETFs are contributing to these bandwagon effects, which could ultimately generate 1987-style portfolio insurance-style risks for the market.

Here is the original article that outlines how frequent portfolio rebalancing among leveraged ETFs "magnifies intraday movement". What this suggests is that volatility itself is becoming more volatile as an increasing number of leveraged ETF participants join the market. Today's trade may just be a harbinger of things to come--and adjustments traders need to make.