Leveraged ETFs and End of Day Volatility
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 predictability of the leveraged ETFs rebalancing that increases end of day volatility.
Comments are closed.