Leverage Thingees

Can you elaborate on what you mean when you say these short sector ETFs invalidate traditional technical analysis?

OK — this will be a little roundabout, but I think I’ll get there, so please bear with me. First off, I believe technical analysis is important because others think it is important (kind of like how Paris Hilton is famous … for being famous!). But I do not believe it is the be-all and end-all — particularly when it comes to derivatives. And indices are derivatives. One of the very first things I learned at Goldman as a trainee was: "Securities are linear, but options are curvy." What that means is that stock prices will follow a linear path, but derivatives follow an exponential path, given the math of the price function.

So if key technical levels are based on a linear path, but all of the sudden you introduce something turbo-charged, you can blow right through a support/resistance level without even knowing it or contemplating the level. Thus, these levels can be manipulated. If I bought up the short index, knowing that the swap counterparty was going to have to hedge, and at the same time started shorting the underlying stocks, I can create two, three, four times the selling pressure. (The same thing goes the other way with the long funds.)

Again, because these ETFs segregate bears and bulls, we never realize true price discovery — this is compounded, because the volume in these sector ETFs can swamp the volume in the underliers. All this adds up to potential for market manipulation — manipulation of levels once deemed sacrosanct.

As a second part to this answer, I mentioned that indices are themselves derivatives. The composition of an index, particularly market-cap-weighted indices, varies over time. The composition of the S&P 500 in 2000 is very different from the composition today. So why is a level we hit in 2000 relevant to me now? Or even closer to home, in the financials index, Lehman and Bear, I am sure, were components at the beginning of the year but are nowhere to be found now. So looking at the index level in January vs. the index level in December is not really an apples-to-apples comparison.

So it is downright laughable to me when I see people talking about technical levels on these levered ETFs — we are talking about a derivative on a derivative (and think about options on these things — we are talking about derivatives cubed). How on earth could one think that a technical level has any validity whatsoever when we look at prices of the levered ETFs themselves when so much is going on with the underliers, the index composition, the NAV distortions, the short volatility play, etc.? Unless the person telling you about these technical levels on levered ETFs holds a Ph.D. in nuclear physics, don’t listen. And as a hint, Ph.D.s in nuclear physics generally don’t believe in voodoo.

OK, two points I disagree with, the suppostiion that manipulation plays such a big role here, and the "unrealized" price discovery.

I don’t so much disagree that someone CAN manipulate them through chart points. But can’t you say that about anything? Why does it invalidate these, but not some relatively thinly traded stock or normal ETF?

And unrealized price discovery? It’s not like all these ETF’s trade in some noise proof back room somewhere. You can segregate them into 10 products, but if one gets out of line with another for more than 3 seconds, an arb will step in and slap them back.

So that being said, I believe his overall take on charting these does make sense. You simply can’t apply the same rules you do to a normal stock or index or ETF if you go beyond 1 day. These are derivatives that reset every day. There’s no such thing as low or high in absolute price. It’s the 50 First Dates of Financial products. They begin every day with a clean slate.  Unless you’ve been hit in the head several times with a baseball, you probably wouldn’t apply your normal charting strategies to a DEEEEEEEP call option, yet in a way it’s a similar principle here.