ETF Manipulation Might Drive Big Drops

Are some of the big drops we see in the market directly related to market manipulation? Scott Rothbort over on Street Insight brought this phenomenon to our attention and I have since done some homework that jibes entirely with what Rothbort's been writing.

What's happening? Right now, ETFs are exempt from the uptick rule (the SEC rule that basically says you can't short a stock on a downtick), meaning you can blow out of ETFs and short them ETFs with reckless abandon.

How are people profiting from this? Simple: They get long puts in all of the important names of some ETFs and then start pushing the ETFs down with short sales, breaking the prices of all of the stocks in the ETFs as the arbitrage pressure naturally pushes the stocks down.

This stuff goes on every day and it is totally legal. You can short without upticks in ETFs. You can buy all the puts you want. The reason it works so well is that the concentrated selling of the ETFs roils the stocks in the ETFs to the point where they break down -- where you caused breakdowns -- and you then can ring the register from your own blast out.

This stuff used to happen in the world of married puts, where you could get long a stock and a put at the same time, then crush the stock with a blowout and sell the put at a profit. The SEC recently outlawed that practice. This game is much better than the married put game, though, because with married puts you still had to be long the stock, which presented some real risk. Here, you can lean all over the ETFs and really cause some mayhem.

I have to admit that until this stuff is found to be illegal, it is a game I would be sorely tempted to try if I were still back at the hedge fund. Sounds like real found money given the interrelation between the ETFs and their underlying stocks.

That said, if I were the SEC, I immediately would prohibit this kind of trading. It is just legal raiding, and it should be stopped.

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James J. Cramer is a director and co-founder of TheStreet.com. He contributes daily market commentary for TheStreet.com's sites and serves as an adviser to the company's CEO. Outside contributing columnists for TheStreet.com and RealMoney.com, including Cramer, may, from time to time, write about stocks in which they have a position. In such cases, appropriate disclosure is made. To see his personal portfolio and find out what trades Cramer will make before he makes them, sign up for Action Alerts PLUS by clicking here. While he cannot provide personalized investment advice or recommendations, he invites you to send comments on his column to [e-mail]. Listen to Cramer's RealMoney Radio show on your computer; just click here. Click here to buy Cramer's latest book, "You Got Screwed!" Click here to order Cramer's autobiography, "Confessions of a Street Addict."