Trading Defenders
Leveraged ETFs and End of Day Volatility
by Dennis Dick on 12/07/11
Do leveraged ETFs increase market volatility? This question has been raised time and time again with no definitive answer. But here is my take.
Leveraged ETFs do a daily rebalancing in order to keep their leveraged exposure intact. If the underlying index that the ETF is tracking, is up on the day, the leveraged ETF must increase their exposure to this underlying index at the end of the day by buying more of the index (usually done through a swap arrangement). If the underlying index is down on the day, they must do the opposite, and decrease their exposure. In essence, the leveraged ETFs are always buying at the end of the day on up days, and selling at the end of the day on down days.
This daily end of day rebalancing is very predictable. Any type of predictable order flow is gamed heavily by predatory high frequency traders. These HFT players will drive the price of the underlying index higher, if they know the ETF needs to buy, or drive the price of the underlying index lower, if they know the ETF needs to sell.
This action leads to increased end of day volatility as the underlying indexes are moved around by predatory players looking to extract the maximum value from the leveraged ETFs predictable rebalancing.
So in essence, it is the predictable nature of the leveraged ETFs rebalancing that increases end of day volatility.
OTC Market Maker Steals 8 Points from Retail Investor
by Dennis Dick on 11/30/11
A new ETN started trading today, the ETRACS Fisher-Gartman Risk-On ETN under ticker symbol ONN.
New issues often lack liquidity as few market making participants jump in to make markets right away. The issue opened for trading at $24.00 and bounced around between $22 and $27 in early trade. Then at 09:51:42 ET, the sell side liquidity vanished for a split second showing the best offer up at $35.
OTC market makers (aka internalizers), are allowed to print retail market orders anywhere within the spread. When the national best offer flashed $35 for a split second, some quick internalization program printed a retail market buy order up at $34.968. The stock immediately traded back down to $27, allowing the OTC market maker to cover for a quick 8 points. The poor retail investor who sent that market order immediately lost the 8 points.
If that retail investor's buy order had been sent to any exchange, it most likely would have been executed at a much better price (as there is often hidden liquidity on the exchanges). But because OTC market makers are not required to send orders to exchanges, they were able to take advantage of the temporarily widened spread at the expense of the little guy again.
The SEC needs to investigate instances like this, and determine whether some of these OTC market makers are really giving best execution, or simply taking advantage of a retail trader's blank check.
Financial Transaction Tax does more Harm than Good
by Dennis Dick on 11/03/11
Representative, Peter DeFazio is at it again. With support from Senator Tom Harkin, the two
DeFazio tried to propose a similar tax a couple of years ago, but the proposed bill never gained much traction. But now that the European Union has proposed a financial transaction tax, DeFazio is hoping that his proposal can gain more support this time around.
The problem is this tax, while in theory, would raise a substantial amount of revenue, it would come with some substantial costs, the most significant being a decline in market liquidity. Market liquidity refers to a stock's ability to be sold without substantially impacting price. The majority of our market liquidity is provided by market makers. These market makers have very small profit margins. A modest transaction tax of 0.03 percent (which is being proposed), would have devastating effects on the market making business. Let's take a quick look at the math.
Many of our most highly traded stocks have bid-ask spreads of one cent. A stock that is trading at $25, would have a transaction tax of ($25 x 0.0003) = $0.0075 per share. If a market maker were to buy this stock at $25 and sell it at $25.01. They would make 1 cent/share, but would have to pay 1.5 cents/share in tax (they have two transactions, the buy and the sell). Therefore they would lose 0.5 cents on the transaction. In order to remain profitable they would have to widen their spreads to a minimum of 2 cents, and possibly further (as market makers aren't always profitable on every trade). Wider spreads means more price impact for institutional traders as they make trades, and this added expense comes right out of the pocket of the little guy who invests in the fund that is trying to transact. These indirect costs could be quite substantial.
The direct cost is that the institution transacting would have to pay the transaction tax as well. So another 0.03 percent comes out of the pocket of the individual investor investing in the fund, every time the institution makes a trade. This number may sound small but imagine an institution that trades 200,000 shares of a $50 stock. The transaction fee on that transaction alone would be $3,000. Many actively managed funds trade much higher volume than that in a single day. These costs would quickly add up.
What would naturally happen is that institutions would become hesitant to trade, and may hold onto a position they would otherwise sell, just to avoid paying the transaction fee. This could lead to large losses in positions that may have otherwise been liquidated.
The benefit to this tax would come in the form of the revenue generated from the tax. But trading volumes would drop substantially, as traders and institutions seek to avoid excessive taxation. This makes any projected revenue raised by the transaction tax much less than what would be raised on today's current market volumes.
Some will argue that introducing this tax will eliminate high frequency trading. Now I'm not a big fan of high frequency trading either, but there are better ways to regulate high frequency trading. This tax would do nothing more than harm market liquidity in a market environment that some already argue doesn't have enough liquidity to begin with (think of the May 6th flash crash).
So let's use some common sense when introducing bills that do more harm than good.
