6 Market Manipulation Tactics & How to Protect Oneself Against Them
N.b., Some of the information contained within this article has been procured from the wisdom of a New York-based hedge fund manager, who I have been fortunate enough to count on as a mentor. All other sources of information are referenced where appropriate.
Manipulation is a part of the financial markets and has been for centuries. It is a common rationalization used by those who might look toward external factors adversely impacting their trading or investing results. They may perceive that well-moneyed market players or insiders are manipulating trading on the exchanges for their own gain to the disadvantage of those “on the outside.”
The unfortunate reality is that whenever money is at stake there will be those who try to game the system for their own means, whether legally or illegally.
The proper perspective toward manipulation is not to develop an unhealthy mindset that “rigging” and “spoofing” is anywhere and everywhere and always detrimentally impacts one’s results. Rather, it should be more properly held that while manipulation may exist in some form, success in the markets is still heavily dependent on one’s own thought, care, analysis, knowledge, and accumulated experience applied to one’s trading or investing.
Manipulation is simply part of the structure of financial markets and how various well-capitalized investors play the game isn’t within the public’s control. Knowing that it can work for you, or against you — or in no particular direction either way — will help to assuage any attendant concerns about practices that may be illegal or unethical.
Moreover, understand that market manipulation is most disadvantageous for short-term traders; not those who are looking to invest over months, years, or decades. While forms of long-term manipulation can and do take place, it is usually short-term in nature and with no specific directional outcomes over the long-run.
Accordingly, the best way for anyone to protect themselves from financial market manipulation is to invest for the long-term. In general, it is a bad idea for smaller investors to trade in and out of the market and try to operate on small timeframes with their investments. Competing on the exchanges directly against well-capitalised institutions that have an information advantage isn’t the best idea because it’s very hard to win like that. It’s like sitting down at the poker table against players who are the most experienced and well-strategised of any in the world. You might win a few hands here and there, but it’s going to be very tough to win consistently.
Understanding the various types of market manipulation can nonetheless help better inform your trading and investing decisions.
1. The “Pump And Dump”
One of the most common financial market manipulation tactics is “pump and dump.” It is designed to increase the price of a stock quickly, with the party promoting the pump then liquidating the position before it decreases.
It is much easier for manipulators — often called promoters — to do this on stocks of very small market capitalisations than larger ones. This is particularly true since the tactic largely relies on convincing retail investors to buy up the stock. Accordingly, it is important for the prices of these securities to move more easily on a dollar for dollar basis than larger ones. It can be thought of in supply/demand terms. When the supply of something is limited (i.e., lower quantity of stock), a large surge in demand will increase its price more relative to if its supply was higher.
The general strategy and sequence behind a pump and dump is as follows:
1. Use various media and communication avenues — e.g., blogs, newsletters, email, social media — to promote a particular stock. This involves writing glowing recommendations of the company and underlying stock. It will generally mention any particular positive operational, strategic, and/or financial attributes perceived about the company.
2. If successful, this attracts retail buyers into the stock, pushing prices and volume higher. Successful pumps are generally sharp and sudden. This corresponds to the surgically timed dispersion of promotional content across all marketing channels. Namely, rather than promoting the stock over the course of days, promoters will prefer to try to do it all within hours or at least within the trading day.
3. Once the pump begins cresting after the initial surge of momentum, this is when promoters begin to sell their shares (the “dump” phase), securing a profit. Naturally, this causes price to fall. Oftentimes this causes price to roughly return back to where it was previously when others begin liquidating their positions as well.
How One May Protect Oneself
Nano-cap stocks — often called “penny stocks” for the fact that many of them trade at very low prices (sometimes even less than a penny ($0.01) per share) — are most vulnerable. Nano-cap stocks are generally defined as those that have market capitalisations of less than $50 million. Micro-cap stocks are also frequently preyed upon, which have market capitalisations of approximately $50 million to $300 million.
In general, pump and dumps can be avoided by only buying stocks of market caps above $100 million. Stocks that are priced at low dollar per share amounts — generally under $1 — are also at risk, because promoters know that retail investors will have the means to buy shares in bulk and will also be more likely to perceive them as cheap.
Note that if by any chance you do own a stock that is subject to pump and dump manipulation, it doesn’t always mean that you will lose money because of it. It is a strategy that inherently involves buying a stock, rather short-selling it. Spreading negative rumors about a company or by heavily shorting it involves separate manipulation tactics altogether.
Moreover, using a take-profit level can help protect against pump and dumps or even fortuitously profit from one. Institutional traders generally use take-profit levels to get out of a trade when a stock hits a certain price. For example, those following the “value” approach to investing will view a business’s valuation as the amount of cash you can extract from it over its life discounted back to the present. Therefore, the idea under this paradigm is to buy a stock when it’s believed that the business is undervalued and to sell the stock when it reaches its perceived fair value price level.
For example, if a trader buys shares at $5.00 and believes the fair value of the stock is $6.50, one could set the take-profit level (essentially a sell order) to that price. In the event that the stock is ever subject to this type of manipulation, one’s position could be profitably liquidated before the dump occurs — depending on how high it goes — and put you on the same side as the promoter.
2. Propagation of False Information
Sometimes what’s out there about a particular company — and therefore its stock, if publicly traded — in the media is a caricature or misleading account of what is actually true. The more popular term today, of course, is “fake news.”
Those of influence in the financial community have the ability to alter financial markets simply through their words. This includes monetary and fiscal authorities, well-known institutional money managers, promoters (as discussed above), and those in the media who can influence news and associated information streams.
For example, it can include central bankers commenting on the future path of interest rates, a popular money manager commenting on a particular company or asset class, or simply a piece of information in a widely viewed or circulated publication/platform stating things that may or may not be factually accurate.
What is publicly known about a particular security is already baked into the consensus and therefore its price. Thus, if that narrative can be altered through whatever communication channel, it can shift the market.
This can sometimes work for you and work against you, and no market or security is immune from it, whether it be stocks, bonds, currencies, commodities, or cryptocurrencies.
How One May Protect Oneself
Unfortunately, it’s impossible to plan for and avoid false information. This, of course, affects everybody and not just smaller investors.
Nonetheless, if fake news introduces an inefficiency into the market, this provides investors with an opportunity. For example, when Facebook’s stock came under heavy selling pressure in March 2018 from concerns over data privacy issues, many investors fled believing it represented a fundamental threat to the company’s business. While this is true, Facebook is still a massively profitable company with a far-ranging social influence globally, which could lead to the competing interpretation that the stock had fallen too far and was on sale at a discount.
It is largely assumed, that provided enough time, the facts regarding a company or particular market will come out in the most accurate light. This provides another argument in favor of investing for the long-term.
3. “Spoofing” or “Painting the Tape”
Spoofing, or sometimes “painting the tape,” is a term that dates back to when securities prices were largely transmitted through ticker tape. It involves traders setting buy or sell orders in the market at a specific price yet with no intent in following through with them.
For example, if a stock is trading at $50 per share, a trader may try to influence other traders into thinking that the price of the shares is rising by putting in a buy order bid for $50.10. The size of the order by necessity has to be large enough to attract the attention of other traders (pending orders can be tracked electronically on the exchanges) who might believe that “smart money” knows something that they don’t. For instance, this might be done in the hours leading up to an after-market hours earnings announcement to plant a false signal in the market about which way the results will go.
As buyers join in, which generally begets more buying as volume tends to attract other traders, the spoofer may then reverse course by canceling his buy order at $50.10 and put in an order to short-sell at $50.10 instead. This order is executed.
Through this, the trader has gotten into a more favorable selling price — $0.10 or 0.2% above its previous price (theoretically closer to its fair value) — and can exit his position at a profit if canceling the original buy order diminishes demand for the security such that it closes back near its original price of $50 per share.
However, sometimes traders will spoof more than once. For instance, let’s say we have equivalent circumstances and the trader did the same thing in the first example:
1. Stock is trading at $50
2. Trader offers to buy the stock at $50.10 in a large quantity, catching the attention of market participants and drawing in other buyers who believe the order means that the current price of $50 is unlikely to hold
3. Trader cancels his buy order at $50.10 and simultaneously offers to short-sell the stock at $50.10
Then, the spoofer may follow the reverse process to lock in profits by doing the following:
4. Offers to short-sell at $50.05 in the same large quantity as above, drawing in sellers and pulling price back down
5. The trader will then cancel this short-sell order at $50.05 and simultaneously buy at $50.05
The net result is that the spoofer short-sold the stock at $50.10 and covered his short by buying it back at $50.05, locking in a profit of $0.05 for each share of stock that he bought.
By doing this repeatedly with proper execution, and with the necessary volume to influence other market participants, the trader can net large profits in a fairly short amount of time, especially if these trades involve leveraging (i.e., borrowed money).
Spoofing is illegal yet can also be hard to detect. Advances in technology have helped the Securities and Exchange Commission (SEC) better detect the practice in recent years by using statistical analysis techniques and analysing any communications for evidence of such.
Yet there are still viable reasons for traders to cancel large orders, particularly among liquidity providers who continuously monitor the supply and demand in particular markets. Switching from a buy order to sell order in rapid succession can make sense to strike the right balance in making a market (i.e., matching buyers and sellers).
Some traders may also not actually be spoofing, but rather simply trying to conceal the size of their trade. This may involve placing multiple orders at different prices. Sometimes it may even involve a large order in one direction, which can help drive the market one way, followed up by an even larger order in the opposite direction (while closing the previous position).
High-frequency trading (HFT) has drawn the ire of some under the pretext that it can be an easy way to manipulate the markets in very similar or even identical fashion to spoofing. HFT relies on supercomputers and algorithms to enter and exit trades in the markets. The proprietary, “black box” nature of what they do also conceals what exactly the strategy entails, though it is loosely labeled as “statistical arbitrage.”
Prosecuting the practice is difficult accordingly. The nature of market manipulation through technological means has nonetheless often called for regulatory intervention.
For example, there is the idea of an “uptick rule,” which has been implemented in various contexts that stipulates that any short-sell order of a stock can only be filled on an uptick from the previous price. This is to prevent short-sellers from piling into a market and pushing prices lower in self-perpetuating fashion due to the loss of confidence (and wealth) this practice can create.
There have also been calls by some politicians and regulators to implement a minimum amount of time that a trader must remain in a trade (e.g., one-tenth of a second). Many HFT trades last for just milliseconds. There have also been proposals to tax each trade such that making any profit off HFT becomes nonviable.
How One May Protect Oneself
Since spoofing is purely a short-term tactic, it can largely be avoided by investing for the long-term rather than trying to day-trade. Most HFT trading strategies compete against each other rather than with other long-term investors. Hence buy-and-hold types don’t have any genuine reasons to believe that spoofing or HFT is distorting markets on a timeframe that is relevant to their own.
Many trading firms who operate on short timeframes have also developed software to help their traders avoid being deceived by those who are spoofing the market.
4. Bear Raiding
Bear raiding is the act of forcing a stock price down to trigger stop-losses, which prompts the liquidation of open long positions, adding to even more selling in a self-reinforcing feedback loop. It can be associated with both directional manipulation and false information.
Traders can either instigate the process by short-selling the stock themselves, maligning the company publicly, or both at the same time. Spreading false information in an attempt to downwardly manipulate stock prices is generally considered illegal, though can be difficult for regulatory authorities to prosecute.
Bear raiding has been common throughout history. To choose a particular example, in 1997, Thailand encountered a debt crisis (i.e., too much debt relative to income available to service it). Consequently, foreigners began to pull their capital from the country in response to perceptions of upcoming economic tribulations. This induced panic in surrounding Asian economies and their respective currencies, including Malaysia, Indonesia, the Philippines, and Hong Kong, aided and abetted by speculators who “bear raided” the currencies, pushing them down.
To counter this speculative activity, the central banks of these countries increased interest rates. Rising interest rates can help increase the yields of local currency-denominated assets, which helps in creating demand for them and therefore the currency.
However, interest rates are also used to calculate the present value of cash flows that comprise stock valuations. When interest rates increase without an attendant increase in the earnings expectations of these companies, stock valuations are likely to fall. The stock markets in these countries, and globally, began declining, and speculators ramped up the pressure to profit off the opportunity in one of the more prominent “bear raid” scenarios in recent market history.
How One May Protect Oneself
Bear raiding is exceptionally difficult to do on mid- and large-cap stocks, as it takes very high amounts of capital to move those markets.
So the general advice here remains the same — avoid stocks with low market capitalisations and securities that have less liquid markets, as these are more easily manipulated than highly liquid, higher volume markets.
5. Wash Trading
Wash trading is a version of spoofing. This is where large traders will buy and sell securities back and forth either to each other or to themselves to increase the volume in a certain market. It often entails the same party selling shares through one broker and buying them through another.
This has the effect of producing no net effect on price (a “wash”) but boosts volume. Artificially pumping volume creates the illusion that legitimate trading activity is taking place and dupes some investors into participating. This is an illegal practice and has been in the United States since 1936.
Many traders who study technical analysis, or market dynamics more generally, believe that price follows volume. Namely, when volume starts to increase with no concomitant increase in price — e.g., because buy orders are initially offsetting sell orders to a large degree, causing no net change in price — it is often believed that the neutralisation will eventually dissipate. When this happens, price will begin to move higher in one direction or another. (This is helped validated by the general accuracy of the statement that volume tends to trend over time).
For example, if price is trending down on low volume and volatility begins to pick up, many traders will interpret this as a bullish signal and surmise that the market is about to reverse its trend. But in the case of wash trading, the activity is not legitimate.
Moreover, wash trading may be used to not only provide the false illusion of demand for a security, it may be used to generate commissions for brokers whose businesses depend on the volume of trading activity and any fees on margins. Therefore, wash trading may entail both a high volume of trades (to generate commissions fees) and involve leveraging (to generate interest fees).
This may be used to indirectly and discreetly compensate the broker for a particular reason. For example, some may use it to generate sufficient fees to maintain a particular brokerage arrangement they might have. Some prime brokerages require a certain level of fee commissions in order to do business with them, with wash trading one (again, illegal) tactical conduit to satisfy this requirement. In return, the prime brokerage allows the trader access to certain markets and financing terms that wouldn’t be obtainable under the normal arrangements associated with retail trading accounts.
Those engaging in wash trading may also have a personal or financial interest in the broker, such as an ownership stake.
Wash trading has already been pervasive in the cryptocurrency markets.
For example, the bitcoin trading platform Bitfinex valued their platform on the basis of their earnings, which predominantly come from trading volumes. To raise funding, Bitfinex offered what it called BFX tokens that were at one point converted into equity in the company.
Based on what’s been written in this section you can probably guess what happened. Well-capitalized people on the platform bought the tokens and wash traded, generating commissions for the platform and boosting the value of their tokens.
To add onto this, the platform itself did not incorporate protection mechanisms against wash trading into its engine. Based on the fact that trading commissions were the bulk of Bitfinex’s valuation, one can make their own deductions regarding whether this exclusion was purposeful or simply an honest omission.
How One May Protect Oneself
As a type of spoofing, this affects mostly short-term trading activity. However, for large investors with prime brokerage arrangements and often multiple trading accounts, it can be continued for an elongated period of time, if they desire to. Wash trading is still nevertheless a price-neutral market manipulation tactic and thus doesn’t inherently go directly against you.
Generally speaking, long-term investors, once again, have little to fear regarding having their portfolio undermined by wash trading. Also, larger stocks (market capitalisations above $5 billion), and markets with larger volume as a whole, have fewer issues with this behavior since it is much more likely to represent a small fraction of overall trading activity.
6. Central Bank Manipulation
Broadly speaking, central banks help guide the money and credit creating capacity of the economies in their respective jurisdictions.
Since the 2008 financial crisis, the role of central banks in the financial market has grown as developed markets have cut interest rates and engaged in asset purchases (“quantitative easing”) to help further lower borrowing costs and incentivise greater lending and borrowing activity.
Regarding accusations of central bank “manipulation” — or at least non-cynical and non-conspiratorial uses of the term — it is with respect to their domestic currencies. Under this consideration, it has been defined as a central bank purchasing foreign exchange in the market. This increases the value of that currency relative to its own currency.
This tactic helps depreciate the currency, usually for purposes of obtaining a trade advantage. Namely, it makes a country’s goods cheaper in relative terms and thereby creates demand for them. Thus they’re able to export more goods and boost GDP. This is common in emerging markets that are in a stage of their development where they predominantly rely on the exportation of manufactured items and/or commodities due to an underdeveloped services sector.
Trade partners will often cry foul at these currency manipulation practices believing it hurts the competitiveness of their own goods in the global market or effectively increases the prices that they have to pay for them.
As countries develop and restructure their economies away from manufacturing and exported goods and toward services and consumption, central banks will generally prefer a stronger or stable currency. This is currently the case in China, for example.
To effectuate this policy, the central bank can sell foreign exchange reserves and buy its own currency. This will work against manufacturers but help consumers, who now have greater purchasing power and importing goods effectively becomes cheaper. This will tend to reduce a country’s current account surplus accordingly (or increase its current account deficit if one exists).
How One May Protect Oneself
When trading currencies, particularly on a long-term time horizon, it is important to understand where each country is in its development.
If it’s still an export and manufacturing dependent economy, a central bank may not necessarily want its currency to depreciate, per se. But it will have an active interest in preventing its currency from becoming too strong to avoid undermining local manufacturers and entrepreneurs who benefit by exporting their goods and/or services based on their relative cheapness to trade partners and domestic consumers. Accordingly, you may be less apt to develop a bullish position on the currency.
Conclusion
Manipulation in the financial markets dates back centuries and it is simply a reality that wherever there is money to be made, unscrupulous behavior will abound.
Most of it, however, is short-term in nature, including such tactics as pumping and dumping, spreading false information, and spoofing. And some doesn’t involve directional price manipulation at all (i.e., wash trading).
One can largely protect oneself from manipulation by focusing on investing and trading over long-term time horizons. Additionally, it is best to avoid stocks that have market caps of under $1 billion. These are the easiest to manipulate since relatively little capital is needed to affect prices. Other low-volume, illiquid markets can also be soft targets for manipulation, such as certain cryptocurrencies.
