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.

Excellent article from the Financial Times today reiterating a problem with open-ended exchange-traded funds like UNG (Natural Gas ETF) or USO (Crude Oil ETF), that trade futures contracts.

Traders are all atwitter about record volume in UNG recently.  But there’s probably an underlying reason, and it’s not necessarily that suddenly everyone’s getting in on the next bull market.

At issue currently is the rampant growth of the UNG, the natural gas positions of which have doubled since last month’s roll. This growth, by the way, is eerily similar to that experienced by the ETF’s sister fund, the USO, earlier this year.

In the UNG’s case, however, the growth has been so large that in order to avoid a regulatory clampdown on its futures positions the fund managers have been forced into the world of over-the-counter swaps. Accordingly, the fund’s swap positions are now 2.6 times larger than its future ones.

To give some perspective, if the fund was to put all that money into the futures market, Jakob calculates it would be equal to occupying 78 per cent of  open interest in the July Nymex contract. Meanwhile, the holding of large swap positions goes against the fund’s mandate as outlined in its prospectus.

They went on to show how rising positions in UNG is coinciding with increasing contango in the futures.

A similar thing happened with USO and Crude Oil.

Let me be perfectly frank…if you’re too lazy to read and understand what you’re trading, then you deserve to lose whatever money you “invest” in vehicles like these.

Source:
The Problem With Commodity ETFs
Financial Times, June 11, 2009

Natural gas has gotten cheap compared to oil. That happens for many reasons one of which is that they have slightly different markets. Oil is an international commodity, shipped all over the world, while natural gas is pulled out of the ground and fed into pipelines that go to manufacturing plants all over the midwest and homes in the northeast.

If you believed that natural gas will move back up compared to oil, you could buy UNG and short USO or buy UNG calls and USO puts. UNG is the natural gas ETF and USO is the oil ETF.

Here there are subtleties too. The oil complex ETFs actually hold futures contracts for the near month. That means that every month they have to roll those contracts forward to the next month. If the futures curve is flat, there is no expense or profit in the roll. If the futures curve is upward sloping (contango) the ETF has to pay up to roll forward and that can have a large impact on the return of the fund. Of course, if the curve is downward sloping (backwardation) the fund makes money on the roll.

The upshot of this is that you are not really buying spot oil or natural gas, rather have a position in the futures which the roll can affect significantly.

Another problem is that UNG has grown so large that it cannot hold enough futures for all the money that has come into the fund. It has entered into swaps contracts with counterparties to buy the gas. So now there is counterparty risk and it is unclear what effect the roll will have on its returns.

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