Cramer rails against VIX trading products: They are 'practically designed to fail'

  • "Mad Money" host Jim Cramer reviews the market sell-off, focusing on the volatility trading that he says accelerated the losses.
  • Cramer says that trading vehicles like the XIV are "reckless" and "should not be allowed" in the market.

CNBC's Jim Cramer noticed on Monday that the stock market's 1,000-point sell-off was being exacerbated by some particularly "toxic" trading instruments.

"I think the velocity of the sell-off was directly related to some abstruse financial instruments that ended up putting a ton of additional pressure on the actual S&P [500]," the "Mad Money" host said.

Cramer was specifically referring to the VelocityShares Daily Inverse VIX Short-Term exchange-traded note, or XIV, a small trading product that lets people short the VIX, the market's volatility index.

Volatility refers to the amount of uncertainty in the size (and direction) of changes in the market's value, and the VIX is sometimes called the "fear gauge."

When the VIX started to rise on Monday, the XIV shorts started to unravel, leading to a tail-wags-the-dog effect that sent the broader market into a tailspin faster than expected, Cramer said.

"Many a hedge fund manager figured they'd take advantage of the market's placid nature ... by loading up on XIV, which was a way to bet against volatility," the "Mad Money" host said. "Of course, the VIX tends to have these huge spikes when the market gets clobbered and you least expect it, and that translated into the utter destruction of this inverse VIX product."

"This inverse VIX thing, the XIV for short, was practically designed to fail," Cramer argued. "It should never have been built."

Others seemed to agree. On Tuesday, Credit Suisse announced that it would end trading for its XIV later in February after the ETN fell some 85 percent in Monday's after-hours session.

Worse yet, those who saw their XIV positions erased then had a cause to sell S&P 500 futures to cover the losses, making the overall effect of the sell-off more drastic.

"I was here telling you it was phony and you had to buy it. I sure hope you listened," Cramer said. "Now, though, we're digesting the selling from this silly inverse VIX product."

And the market, or at least the broader averages, might be closer to bottoming than investors think, the "Mad Money" host said.

By looking at the S&P's proprietary oscillator, a technical tool that measures buying and selling pressure in the index, Cramer determined that stocks could be close to turning around.

When the oscillator fell to a negative-6.8 reading on Monday, Cramer perked up.

"Any time it goes below negative 5, that's considered very oversold and tends, almost always, to lead to a bounce," he said. "If you look at the history of the last three years, though, ... we only have five periods where the oscillator got this low and four of them turned out to be fantastic buying opportunities."

The first happened in August 2015, when fears of a slowdown in China caused waves of selling. In the next two weeks, stocks jumped almost 6 percent as worries abated.

The second was in January 2016 when oil prices tanked. One week later, stocks had rallied nearly 4 percent.

The third, also oil-related, happened a month later in February 2016 when oil slid back down to its lows. But in two weeks, crude stabilized, sending the market rallying 6 percent.

The fourth happened just before President Donald Trump's election, when the market got hammered, then turned around and rallied almost 4 percent two weeks after he won.

"Here's my bottom line: today's bounce was a relief, but don't let it go to your head, please. Just because we had a big up day does not mean we solved all the problems that caused us to get slammed yesterday and last week. Inflation and rising interest rates are still with us and they are a negative," the "Mad Money" host said.

"But that said, today was a textbook example of why you never want to panic, because there's always a better moment to sell than into the teeth of a decline."

WATCH: Cramer vets the market after a multi-day sell-off

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