ETFs should not be allowed according to Jim Cramer

Discussion in 'ETFs' started by Robert Weinstein, Dec 2, 2008.


    Are ETFs forcing stocks down at times? Scott Rothbort had a fantastic article yesterday afternoon on the role of ETFs and whether they can really affect the market.

    I think it is somewhat persuasive, but it does not answer the question that someone can use these instruments, particularly the Bear Ultra Funds, to manipulate the close of the market given that there are market on close orders that must be placed at 3:40 because of the nature of the project. If you come in with guns blazing, you are directly going around the margin rules to be able to blast out stocks to accentuate the direction of the market. You get 3-to-1 leverage on top of the 50% leverage you can use, allowing for some serious firepower to take the market down. I understand the notion that the "solution" these funds use is to employ swaps, but as always, the swaps are simply the stocks all over again in a different form, one that the stock market by the way simply can't handle owing to the velocity of the moves.

    Put simply, I regard these products as a derivative of portfolio insurance, a direct cause of the 1987 crash, because the market could not handle what was then known as dynamic hedging. That's the same as these ETFs -- weapons of mass destruction that retail investors and institutional investors can use both as a hedge and as a way to take the market down after putting on massive shorts all day.

    If you combine these with a targeted approach that can move Exxon (XOM - commentary - Cramer's Take), one of the biggest players, and Chevron (CVX - commentary - Cramer's Take), another important portion of the index, through shorts and puts and the oil ETF, you can push the market down even faster, as Rothbort admits that the sector ETFs have big impact.

    I am simply saying that if I wanted to do so, I am confident that with little cash I could collapse the market using these triple pro-bear products in conjunction with other ETFs to take this market apart at 3 p.m., with the real damage coming after the adviser to the fund puts in the market on close orders that can then be run ahead of, causing additional chaos.

    It's just too easy. The instruments should not have been approved. They are too powerful with too much leverage at a time when we are trying to eliminate the leverage. Of course, you could argue that you could blast things out with S&P futures themselves, but these pro-bear instruments have tremendous firepower and can lead to these amazing closes that we have seen.

    Robert Weinstein responds -

    Today I read an online article by the well known Jim Cramer and couldn’t believe what I was reading. If the truth be told, I don’t know that much about Mr. Cramer. I don’t watch his show on a regular basis (only maybe a total of 3-5 times ever) but I also don’t have an axe to grind. For me he is just another talking head on TV and my XM radio as I drive how from work later than normal.

    Seeing online how the markets did after the close I came across an ETFs Are Too Powerful by Jim Cramer. This article seemed interesting and after reading it I was given the feeling that Jim Cramer may actually believe that we are all to bow down and give thanks to him for not destroying our portfolio (at least more than the market has done to many).

    Based on my understanding of what Mr. Cramer is saying anyone with a few dollars (too few based on his theory) could drive the stock market down at will by using the all powerful Ultra funds which have internal leverage built into the price. Mr Cramer goes on to say that he blames the types of products that encompass leveraged ETFs as the ’cause’ of the 1987 stock market crash.

    I would expect this kind of analyst to come from some day trader trying to explain to friends at a dinner party why he blew out his trading account. “oh, I was doing fine and making money until someone decided to short the ultra ETFs” would be how that conversation would flow. I might even roll my eyes at some over ambitious regulator that thinks the only problem we have to fix is to add more regulation so as to avoid the market from ever going down again.

    Perhaps that is the camp that Mr. Cramer belongs in. He says that “The instruments should not have been approved”. I could not disagree more. While I do not trade Ultra ETFs I have traded enough to know that markets have had crashes and corrections before ETFs came on the scene. I can not agree that ETFs can cause a market to crash and stay down by the works of one or even several money players. To agree would mean to also disagree with some of the greatest stock traders ever including the legendary Jesse Livermore as well as countless others who believe the market is bigger than any one person.

    Discounting Mr. Cramer as being wrong right out of hand may be a little bit of a rush to judgment so lets take a little closer look at the facts. I will start with the Ultra S&P double shot SDS. The SDS is not 3x as Mr. Cramer suggests is the problem illustrated in his blog but its a good starting point. Based on Mr. Cramer if you buy the SDS and use your full margin by going all in your able to have an effective leverage of four times your capital. This I agree with. Where we part in thought is the idea that market crashes can happen that would not happen otherwise.

    First error in this theory is that someone who has enough money to move the market is trading with an account that is subject to Reg T. Margin (2x overnight). Perhaps if he would have started out with a professional trader that can command 5 or 6 times overnight margin we may actually be able to move forward and see where it leads us. This fact alone makes the argument mute.

    The next area that I think causes this theory to vaporize like a desert summer mist is that Mr. Cramer is suggesting that the perpetrator of a market crash use all leverage available or at least has the appearance that most of it is used. That may look good on paper like a Martingale money management system but when put into practice its easy to see that you may have an issue if it ‘doesn’t work’ and then you are left to cover. I can say with experience that its not an economically enjoyable activity to work your way out of a losing position when you have way too much size. This reason alone is why I feel we won’t have to worry about giving thanks that Mr. Cramer doesn’t send the markets crashing down on the next close.

    Even if you say that this one ‘is different’ and that they really are dangerous and need to be taken away and left only in college finance textbooks on what used to go wrong you still have another problem. The most common traded futures contract is the e-mini and its leverage is far greater than any of the Ultra long or Ultra bear ETFs you may find at your favorite broker.

    If a person or group of people could actually make money by crashing the market how do we ever make new highs? Why would the market not be crashing all the time? The reason is simple in that the market will move to where its SUPPOSED to be more efficiently as a result of derivatives not in spite of them.

    Who trades ETFs? Is it big money that is trying to ‘move the market’? Not as long as you can get a lot more bang for your buck with futures (along with a host of other benefits over stocks like tax treatment, lower cost, overnight trading etc..). Ultra ETFs are used by day traders trying to gain a stronger position but not to the point of wanting to be more highly leveraged like futures offer.

    What about the argument made by Mr. Cramer that in a time of ‘trying to eliminate the leverage’ Ultra ETFs are ‘too powerful with too much leverage’? Its not the four or even six times leverage that put us in the mess that we are in. LEH and BSC were faced with losses when they had 20x and more leverage (while we can see how that worked out for them its a world apart)

    We all know the guy who has lost money (sometimes over and over) and its never his fault. Always the market did this or that happened. “If only the market was not manipulated I would be able to make serious money” is another of my favorites. The idea that ETFs will cause you to lose money is just another excuse to be used to explain why so and so can’t outperform the local passbook savings account.

    Some may fear the Ultra ETFs but I for one will sleep well at night knowing that the market with or without the Ultra ETFs will not change my trading results at the end of the year and so should you.