So long as we’ve dredged up a little Cramer, how about we at least have a takeaway from it.

Allen was kind of enough to post this Howard Simons response to the “Great Ultra Market Knockdown” discussion over on Real Money.

Variance Swaps and ‘They’
6/22/2009 4:03 PM EDT

Charles, recall how when W.C. Fields was asked by the rube, “Is this a game of chance?” he was told, “Not the way I play it.”

One of the bigger contributors to end-of-day extensions is position-squaring by market makers in variance swaps. Variance moves as the square of volatility, so on such a day as this when the VIX is up about 10.7%, these market makers have to sell ever-greater quantities of stock at ever-lower prices to hedge. This process works in reverse, too, and I believe much of the kick higher after March 10, 2009, was attributable to the unwinding of such hedges.

But you have to get with the program. Buyers are not “they.” Sellers are “they.” And that extends to the various leveraged ETFs, too: Leveraged-down is bad, and leveraged up is, well, not so bad.

Now I can’t verify his numbers are correct, but the principle is spot on. Consider “they” as anyone effectively short market volatility in some fashion. Be it variance swaps, SPX straddles, whatever. And yes, even Ultra ETF’s. A third party that creates them for Direxion or ProShares is effectively short all he has created. Not every player in every product flattens out at exactly the close of each day, but it’s certainly a force on the margins. And the bigger the move, the more you need to hedge, so it can feed upon itself. Cramer’s Evil Cabal is often a quant-ish trader or hedge fund simply evening up. And yes, that evening up can take the form of shorting into weakness and chasing strength.

Now hedgies and traders not actually short volatility can indeed pile on, knowing they can squeeze the aformentioned players. Or at least try to squeeze them. But it’s not a layup to buy at 3pm every strong day and sell 3pm every weak day. It’s perhaps a good odds move, but it’s a risk trade that gets squeezed too in it’s own right.

And we haven’t even touched on actual longs selling stocks. That’s been known to happen too.

Bottom line is it makes better TV to have some Sith Lord sitting around controlling every market in the world, but it’s a bit more complex in reality.

So after all the fuss about Leveraged ETF’s causing their own late day melt downs and melt ups, is there any evidence it actually happens? I mean stocks have closed low and last or high and last forever. Has that pattern of accelerated as leveraged ETF’s gained popularity?

Just to refresh, the concept is that Third parties create these ETF’s for Direxion and ProShares, and those Third parties need to rebalance at some point each day in the direction the ETF is moving. The thought being that this large natural player was piling onto moves already in progress, in addition to hedgies and traders fronting them.

Michael Stokes of MarketSciBlog thinks that there’s not much to see here.

Now I don’t know if traders are seeing a surge in volume near the close (because I don’t trade intraday), I don’t know if leveraged ETFs are responsible for today’s higher levels of market volatility, and I don’t know if leveraged ETFs add potential systemic risk should the market make a really big move up or down (a’la Oct. 1987).

But I do know that, leveraged ETFs are not pushing the market to close at intraday extremes with any more frequency than has been observed historically.

….A simple test. The graph (click thru to see) ….. shows a 1-year rolling average of the % of days that the SPY closed in either the top or bottom 20% of its intraday range (blue, left scale) and/or the top or bottom 10% (red, right scale), from early 1993.

From today, the market has closed in the top/ bottom fifth of its intraday range (blue) 52% of the time, and in the top/bottom tenth 30% of the time, over the last year. And while this is slightly more than the average over the entire test of 49% and 28%, it’s still very much in line with historical norms.

I do believe volume patterns have changed since the popularity of these pups have increased, but that may be sector specific. Financials for example now regularly see the biggest surge in the last few minutes, whereas formerly volume peaked near the open. But it’s interesting that a basic study of price performance shows relatively minor tweaks.

Bottom line I found playing around with this trade is that it only really worked well in the financial sector. That is, if you bought SKF or FAZ in the last hour on an already ugly day, you likely had good flip if you sold it out at the bell. But a combo of everyone in the world gaming this thing, and financials just not moving nearly as much these days, seems to have ended the play

“Will Leveraged ETFs Put Cracks in Market Close?

New research suggests that on days when the indexes make big moves, leveraged exchange-traded funds could trigger a trading cascade, turning the market close into a buying or selling frenzy.

To be fair, there has been no meltdown — yet. But as the financial crisis has intensified since last fall, the final hour of the trading day has felt rougher than ever.

Leveraged ETFs offer double or even triple the daily return of a market index. Some of them, called “inverse” ETFs, move opposite to the market — for example, going up twice as much as an index goes down. Each day, they all adjust their exposure by rebalancing, or “releveraging,” their positions.

These funds are the hottest thing on Wall Street. In March alone, $3.4 billion of new money poured into ETFs that use leverage to magnify the returns on U.S. stocks.

Further amplifying the ETFs’ actions: Every day, trading desks at big banks and brokerage firms blast out customized spreadsheets to favored clients. These tools, linked to live data feeds, predict whether the leveraged ETFs will be buying or selling as 4 p.m. approaches. That enables hedge funds and other big investors to trade ahead of the ETFs.

The excessive trading set off by releveraging is perfectly legal — but upsetting to many people. “The market doesn’t seem like a fair, level playing field,” says Andrew Brooks, head of U.S. equity trading at T. Rowe Price in Baltimore.

Now a respected analyst — Ananth Madhavan, head of trading research at Barclays PLC’s Barclays Global Investors — has released a report arguing that the potential ripple effects of releveraging have been underestimated.

Leveraged ETFs usually generate a multiple of the market’s daily return by using something called a “total-return swap.” Imagine a fund with $100 million in net assets and 200% leverage, meaning that it seeks to deliver twice the market’s daily return. That requires the fund to maintain $100 million in swap exposure.

In a long swap, a counterparty like a bank or brokerage firm agrees to pay the fund $2 for every $1 rise in the closing value of a market index that day. On the other hand, if the market falls, the fund must pay the counterparty 2-for-1.

Now let’s say the fund’s net assets grow by $10 million during the day, to $110 million. The fund must raise its swap exposure from $200 million to $220 million to honor its 2-for-1 investment objective. That is $20 million in extra buy orders, all coming into the market after 3:30 p.m., typically in the final 10 minutes.”

This is corrected below. It can maintain its two for one return with $105 million in swaps.

“An inverse fund also must buy on a day when the market is up; since the value of its hedge has gone down, the fund must increase its exposure to keep its leverage ratio constant. Thus, all these ETFs buy in lockstep in the last few minutes of an up day for their index — and sell in a swarm at the end of a down day.

Mr. Madhavan estimates that if a market index moves 15% in a day, leveraged ETFs could constitute 75% of all volume at the close of trading. Remember, the Dow fell 23% on Oct. 19, 1987. A major move could send volatility through the roof, and prices through the floor, in a day’s final minutes.”

This is an argument that the ETFs could cause a meltdown like portfolio insurance did in the Fall of 1987.

“Narrower markets may already be feeling an impact. William Bernstein of Efficient Frontier Advisors says that between 2002 and 2007, there were only two days on which U.S. real-estate investment trusts went up or down by an average of more than 5%. Since the beginning of 2008 there have been 83 such days. That period includes the collapse of the real-estate market, of course, but also the rise of leveraged real-estate ETFs, which command $1 billion in assets. Trading in the largest of these funds averages about 8% of the total dollar volume in daily REIT turnover.

“I don’t want to sound like a Cassandra,” Mr. Madhavan says of the ETF releveraging, “but this could create a lot of problems. Could it lead to a systemic risk? We may not have seen the biggest effects yet.”

Many people don’t share Mr. Madhavan’s concerns. (His employer is affiliated with iShares, an ETF outfit that competes against leveraged funds for market share.) Across the U.S. stock market, estimates portfolio strategist Phil Mackintosh of Credit Suisse, leveraged ETFs typically account for “less than 4% of total trading in the last hour.”

Andy O’Rourke, head of marketing at Direxion Funds, says his firm has researched the potential impact of daily rebalancing by its leveraged ETFs, “and it hasn’t really been significant enough to have a big impact.” ProShare Advisors, the largest provider of leveraged ETFs, is studying Mr. Madhavan’s report and hasn’t had time to fully critique it. But Michael Sapir, ProShares’ chairman, says: “Our initial view finds significant holes and unsubstantiated conclusions in the report.”

The market’s shrewdest players use the releveraging by ETFs to their own advantage. The rest of us are left reaching for the Rolaids. Here’s hoping the side effects never get worse than that.

Corrections & Amplifications
A leveraged exchange-traded fund with $100 million in assets can achieve 200% exposure to an index with as little as $100 million in total-return swaps. A previous version of this column incorrectly said that this level of exposure would require $200 million in swaps.”