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Leveraged ETF bulls could be bad news for stocks

Day traders took a decidedly bullish stance last week, but the optimism could point to more short-term turmoil for stocks.

Equities traders put 6.8 percent of assets into U.S. leveraged long exchange-traded funds in the past week, while pulling 7.9 percent of assets out of leveraged short funds, according to a Monday report from investment research firm TrimTabs. The weekly inflows were the biggest this year, and outflows were the largest in seven weeks.

The volatile funds move with or against an indicator like the S&P 500, and are designed to rise or fall two to three times as much as their benchmark. Flows last week, when stocks plummeted early on only to mount a sharp reversal, could signal more volatility in the near term, according to TrimTabs.

"Traders of leveraged ETFs, most of whom are day traders and retail investors, have turned extremely bullish on stocks, which is a negative sign from a contrarian perspective," TrimTabs said in the report.

Traders work on the floor of the New York Stock Exchange.
Getty Images
Traders work on the floor of the New York Stock Exchange.

A two-day dip put the S&P 500 in correction territory last Monday and Tuesday. Taking a bullish sign from levered ETF flows makes sense, as they were a logical way for traders to bet on a rally the rest of the week, said strategist Michael Khouw.

Read MoreStocks' dramatic slide hits ETFs

But using the funds as sentiment indicators can present problems. Leveraged ETFs make up about 1 to 1.5 percent of global ETF assets under management, noted Sylvia Jablonski, managing director for capital markets at Direxion Investments.

She added that traders can play both the long and short side of levered ETFs to take a short-term outlook and hedge, blurring sentiment.

Further, the huge short-term swings in the funds lead to traders holding them for a few days or less in many instances, said JJ Kinahan, chief strategist at TD Ameritrade. He noted that, as traders could have already shed positions in long ETFs after trading last week, previous flows may not capture sentiment.

"Leveraged ETFs certainly tend to be in and out," Kinahan said.

Read MoreUS-based stock funds post $17.8B outflows in latest week

China-driven panic selling shook markets at points in the week. Therefore, it may not serve as the best snapshot for investor sentiment, added Scott Nations, president of NationsShares.

"I think what we saw last week was more or less in a vacuum," he said.