Thomas Kee StockTraders Daily.com

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Investors are quickly realizing how double weighted ETFs like DDM, DXD, QLD, QID, SSO, and SDS diverge from the Market over time.  They are usually good at following the market proportionally throughout a single trading day, but because they reset every day, they also diverge over time.  This could present problems for persons interested in holding these over time as well.

However, a similar problem exists on occasion intraday.  This is especially true when important news events cause the Market to become sporadic, like Cisco Systems (CSCO) did on Thursday.  In turn, that causes volatility levels to rise, and that causes abnormal fluctuations in the underlying entities carried by the double – weighted ETFs.  In addition to core holdings in individual stocks (shown below), these ETFs also hold substantial positions in leveraged options.  That is where the abnormal volatility comes from.

For example, on Thursday, August 06, 2009 the NASDAQ was lower by 0.66% at 10:20 AM.  QLD, which tracks the NASDAQ intraday, was down 1.66%.  That is a 25% discrepancy.  Why would this happen?  There are a few reasons:

• Bid and Ask for the ETF.
• VOL increases.
• One of the core positions fluctuates wildly.

First, the Bid and Ask is an issue.  Remember, these are openly traded instruments, just like stocks, and the more buyers out there, the higher the price will go, and vice versa.  So, if there are more people on the Ask, and wanting to sell, the underlying entity will decline more.  In this case, QLD did exactly that.

Also, VOL, or volatility, is extremely important.  That affects options prices.  It the Market becomes more active, the option prices will usually increase in relation to that.  This can cause the underlying value of the ETF to fluctuate even though the Market itself may not.  However, this is also what causes these ETFs to act as leading indicators quite often.

The Poor Man’s Flash Quote.

In fact, that is a key benefit of these ETFs to active traders.  They allow us to determine direction a little bit in advance.  Call them a “Poor Man’s Flash Quote.”  We get a glimpse at where the Market is going a few seconds before the Market actually goes there.

I guess the real question is, has Goldman Sachs (GS) created a master program that will catch this discrepancy in advance too?  Maybe that is why these ETFs carry so much volume.  Is it all based on Flash Trading?  Only time will tell, but my guess is that Flash Trading has a lot to do with the volume in these ETFs.

In relation to my third point, If AAPL were to fluctuate wildly, so would QLD.  The list below shows the major holdings as of 8.5.09.  AAPL was at the top, with over 14% exposure.  It would obviously cause more volatility in the portfolio if it started to gyrate.  AAPL, by the way, is usually at the top of this list.

In the end, all we can be sure of is that these ETFs are designed to track the intraday moves, and after the Market has settled down, they usually do.  Depending on the basis of the ETF, short or long, these usually perform in line with their purpose intraday after the news has settled into the Market.  However, they will move more aggressively than the Market from time to time, and that can be used to our advantage.  They are leading indicators, and they could be used to anticipate direction.

Practice using them by watching them closely, and compare them to the Markets to see how they work.  Active Traders can use this effectively.

List of holdings in QLD as of 8.5.09:

Thomas H. Kee Jr. is President and CEO of Stock Traders Daily, founder of The Investment Rate, architect of the ATAP Program, and supporter of proactive trading strategies.  His work can be found in Reuters, Barron’s, MarketWatch, and other Financial Media Channels.