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SKF Wags the Dog

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What could cause melt in underlying stocks.

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e) {}" href="http://4.bp.blogspot.com/_dFwaKOYqt-A/SaLAinOhNqI/AAAAAAAAFtg/1qWwGoz0hc4/s1600-h/Racer_X.jpg"> A reader whom I'll call Racer X sent me some numbers on Friday with regard to SKF.

And Friday's numbers were even more staggering than last week's. What's it all mean?

Each share of SKF (or any equity ETF, for that matter) could be arbed against a basket of the underlying. In other words, if someone owns 100 shares of SKF, he could theoretically lock in money if he could buy the entire basket of stocks in the IYF for less than he paid for SKF. Conversely, a short in SKF could theoretically lock in money, shorting the whole basket of IYF stocks.

All the above, of course, adjusted for the leverage and the dollars involved.

The salient point is that the stocks in IYF will move in line with the price of SKF on a given day. And if SKF volume comprises such a huge percentage of volume in the underlying names, you clearly have the potential for a "wag the dog" situation.

For example, let's say Evil Short Manipulating Hedge Fund Guy buys 1000 SKF at $195. That translates into $390,000 of financials that the opposite side of the trade has now gone long. JPMorgan (JPM) comprises 9% of that. So one trade produces about $36,000 of selling pressure on JPM, or about 1800 shares.

Now remember, 40 million shares of SKF traded Friday. As did 32 million shares of FAZ, which translates into an additional $7 billion of so in the financial space.

Before we get all conspiracy-theory, keep several things in mind. Remember that most shares of these pups just flip between parties. Over and over again, they're primarily trading vehicles. At least, they should be.

The point, though, is that potential exists for someone to cause their own meltdown in the underlying stocks when the volume of the ETF can account for such a large percentage of the volume of the underlying. In the above example, the volume accounted for by SKF actually exceeds the volume in TRV.

What to do? My friend George jokingly suggests we create an ETF czar. But seriously, it's entirely possible no one actually thought these pups through from any standpoint when they allowed them to be listed. Between the compounding math that ultimately trashes them, to a situation like this where they got too big and too popular and have now become the de facto market in financials, they truly should not have gotten to market.

But hey, who could have possibly imagined this?
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No positions in stocks mentioned.
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