Leveraged Market

Paul Rowady writing at Alphacution says 67% of securities in US stock markets are derivatives dependent on an underlying 33%, made up of company stocks. It’s leveraged.

We can talk about ramifications at the end. To begin, the point is to understand, investors and investor-relations professionals, what it means to how stocks perform.

A derivative is a security that gets its value from an underlying asset. Mr. Rowady is referring to the proliferation of stock and index options and exchange-traded funds (ETFs) predicated on stocks.

It seems helpful to understand the linkage between how the market falls or rises, and how instruments that are derived from shares comprising market capitalization contribute to these cycles.

With derivatives outnumbering stocks two-to-one, the market behaves in a sense like a 2x leveraged vehicle, such as QLD, the ProShares Ultra QQQ ETF, which aims to correspond to two times the performance of the Nasdaq 100.

I’m oversimplifying. For a pure comparison, all the derivatives would have to be long, and they’re not of course, and there’s wide disparity in performance among securities across the market.

Follow me here.  Leveraged markets compound performance both directions. Take QLD. Suppose its underlying asset, the Nasdaq 100 represented by QQQ, is up 5%. QLD would rise 10%. Say for simplicity QQQ trades at $100. QQQ closes at $105, QLD at $110.

QQQ then retreats 5% the next trading day, back to $100. QLD closes at $99, 10% below $110. Compound that daily 5% up-and-down pattern over 30 days and QLD loses 50% of its value while QQQ is still worth $100.

Borrowing is leverage.  If I buy 100 shares of AAPL and borrow $15,000 or so to buy another 100 shares, and AAPL drops 8%, I’m down not 8% but the compounding effect of losses on the asset serving as collateral. I may be forced to sell core portfolio positions to cover my losses on borrowings.

Routinely, brokers are borrowing stocks to supply to ETF sponsors like Blackrock for the right to create ETF shares. We’ve studied shorting in ETFs and component stocks and have found them inversely correlated – validation.

Borrowed stock here isn’t a bet on declines but a defined value. If I exchange $1 million of borrowed stock for the right to create ETF shares that then fall to $950,000, I’ve lost 5% of my money.

I’ve got an obligation to cover borrowings even though I’ve lost money creating and selling ETF shares.  I may be forced to sell something else to align value at risk with internal compliance requirements.

This isn’t a dissection of detailed trading practices but rather a reflection on what can happen in volatile markets when leverage is pervasive. At Jan 7, 48% of all stock-trading volume was short – borrowed. That’s 1x leveraged. On top of the derivatives-to-stock ratio.

When considerations of losses or gains on leverage are ubiquitous, the market isn’t a reliable barometer for how the economy is faring, what investors think of trade practices or government shutdowns, or how your business is performing fundamentally.

The good news is it’s measurable! IR pros, we track every day what behavior is long or short, the role of Risk Mgmt reflecting leverage, and what trends signal. Investors, Sector Insights meter Sentiment, behaviors, shorting, intraday volatility and other factors by industry group.

Investors, you can turn market structure to your advantage (ask us about Market Structure EDGE). IR people, you can proactively inform management – a key action as chief intelligence officers for the capital markets. Ask us how to learn more.

Is there systemic threat in leveraged markets? Of course. We wrote about how stocks have taken on characteristics of a credit market, and credit is always leverage, which grows where interest rates are low and money is artificially plentiful. The reset at the end of the gravy train tends to wipe out leverage.

When? Who knows?  Debt deflations that follow credit booms begin with outlier failures that cause people to say, “Huh. Wonder what happened there?”  Let’s watch trends.