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Volatility & Footprint Size Lead to Marketplace Inefficiency in Leveraged Derivative Trades

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Eric Oberg ran a 2 part series explaining why the returns on many double leveraged EFTs are less than one might expect.

The leveraged trades against the S&P 500 represent a small amount of volume compared to the EFT volume short financials or real estate (like SRS)..thus the trades against more liquid indexes do a better job of tracking their goal (of providing a leveraged mirror of what happened in the marketplace). In the smaller markets the derivative leveraged trades create a lot of marketplace volume that can overshadow the market and dislocate capital.

If someone buys that short-sided ETF from a market maker, the market maker does not really have “the other side” to mitigate his risk, thus he either waits for someone to unwind a pre-existing position or he goes out and shorts the underlier. This puts pressure on the underlier, which creates more interest in being short. This, magnified by the leverage, magnifies the volatility, which magnifies the negative convexity, which eats into returns. Thus the “savvy trader” who thinks he or she is doing a “smart trade” is contributing to his or her own underperformance while still having the right idea — the wrong execution of the right concept.

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December 26th, 2008 at 3:36 am

Posted in investing

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