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Stock Market Manipulation: Definition And How It Works

Updated: Feb. 06, 2023By: Richard Lehman

Market manipulation is when someone interferes with the normal course of stock trading or pricing to further their own gain. Understand the different ways that people may attempt to manipulate the market.

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Market Manipulation Defined

Market manipulation is a general term that describes activities that interfere with the normal process of securities trading, pricing or capital transfer. When such activities have the potential to create an unfair trading environment or disrupt order or capital flow, they constitute fraud and are illegal. They also become a serious concern to the Securities and Exchange Commission (SEC), the federal government agency responsible for maintaining fair and orderly markets, as well as FINRA, the industry’s self-regulatory organization, and state securities regulators.

In the SEC’s words, “Market manipulation is when someone artificially affects the supply or demand for a security (for example, causing stock prices to rise or to fall dramatically). Market manipulation may involve techniques that include: spreading false or misleading information about a company; engaging in a series of transactions to make a security appear more actively traded; or rigging quotes, prices, or trades to make it look like there is more or less demand for a security than is the case.”

Note: There are a great many individuals and organizations involved in stock trading, sales, capital raising, research, news dissemination, and other market-related activities, whose actions affect the markets in one way or another. There is often a gray area between the legitimate activities of these players and the fraudulent activities of those intentionally seeking to manipulate trading for their own gain. It is the responsibility of the regulatory organizations to determine when such activities are fraudulent and to stop them, but it is also important for investors to understand them to avoid being victims.

Methods Manipulators Use to Sway Prices

1. Spoofing

"Spoofing" is the act of placing fake orders and then canceling them before they execute. Investors at large often assess pending buy and sell orders to gauge whether the market is bullish or bearish on a stock for the near term. Spoofing can therefore give these investors the false appearance of a large amount of interest on one side of the market or the other when it isn’t really there. The bogus orders thus induce real buyers or sellers to behave a certain way so that the spoofer can take advantage of it.

2. Wash Trades

Offsetting trades that are placed for the purpose of misleading the market rather than actually acquiring or liquidating stock are called "wash trades". Wash trades can occur by the same player through two different brokers or as a collusion between a trader and a broker. It could also involve offsetting trades in the derivatives markets as well. The phony trades are meant to suggest activity on one side of the market that doesn’t exist.

3. Pump and Dumps

A "pump and dump" scheme involves a player accumulating a stock position and then issuing unrealistically optimistic comments about the company to attract buyers who will further bid up the price. The player then sells into the rising stock price to make a profit. Pump and dump schemes are typically implemented on small or microcap stocks, where there is a better chance of impacting the price of the stock with false news and a better chance of attracting retail investors who are more susceptible to that message.

4. Painting the Tape

"Painting the tape" is a reference to the days when stock trades would print out on ticker tape. It is an action meant to provide a false signal of heavy activity on one side of the market. In reality, the player has an accomplice who is conducting offsetting trades elsewhere. This is also called “marking the close” when it occurs at the end of the trading day.

5. Bear Raids

In a "bear raid", a player takes a short position in a stock and then issues negative or alarming comments on the stock (referred to as a "short attack" or “stock bashing”), which are meant to induce shareholders to panic out of their positions, thereby lowering the price of the stock. The intention of the player is then to close their short positions at much lower prices for a profit, even if the negative information they shared was inaccurate or exaggerated.

How Do Short Sellers Impact Stock Price?

Many investors, traders, and hedge funds engage in short-selling to profit when stocks decline in price. Short-selling has been called into question in the past, with some people blaming the activity for adding to the severity of market declines, but the regulatory bodies and industry professionals have determined that is not the case and see it as a legitimate practice that has a positive overall effect on market efficiency and liquidity.

However, while short-selling is legal, manipulating the price of a stock downward to profit from short-selling (a bear raid) is not. (Pump and dumps to manipulate the price of a stock upward to profit from long positions are just as illegal.)

The uptick rule requires short-sellers to sell on an uptick in price (a higher price than the previous transaction), so short-selling does not necessarily drive the price of a stock downward, though it can have the effect of holding the price from rising by providing additional supply. Eventually, though, every short sale must be closed by a long purchase, so the pressure that holds price back now will lead later to extra buying pressure when the short-seller covers their position.

Conventional short-selling involves borrowing the shares and selling them. That way, the seller delivers shares to the buyer and the seller is obligated to repurchase the shares later to return the borrowed shares. Short-selling can also, however, be considered “naked” if the seller has not borrowed stock to sell. Naked short-selling is not legal.

Short-sellers also have to pay a fee to borrow shares and are subject to margin requirements that help ensure they will have the money to repurchase the stock later to cover (close) their short position. If the stock rises in price instead of declines, the short-seller can be required to put up additional margin capital. As the stock continues to rise, the seller must keep adding capital and when they run out of capital or are otherwise distressed about their losses, they can be forced to liquidate some of the position at a loss. A rising stock thus becomes a “short squeeze” for the short-seller, who may not have the luxury of waiting things out until the stock drops again. As the popular saying goes, "the market can remain irrational longer than you can remain solvent".

Studying Bear Raids

Two professors from the Wharton School studied bear raids and concluded in 2008 that they have characteristics not found in situations where investors collude to drive price upward instead. They determined that Bear Raids have the ability not just to affect investors, but to cause harm to the company by affecting its business prospects, capital-raising ability, etc. This means that bear raids may be more destructive than bull raids or pump and dumps. Accordingly, the regulatory bodies are aware of the dangers of bear raids and keep a close eye on short sellers for any fraudulent activity.

Tip: Seeking Alpha gives subscribers the ability to screen stocks for positive ratings and for their level of short interest (outstanding short positions as a percentage of a stock’s total float). This enables an investor to identify stocks that could eventually rise when short-sellers close their positions or when short squeezes occur.

Bottom Line

Intentional market manipulation is illegal. Nonetheless, it can take many forms and it does exist in the markets. Manipulative practices tend to be short term and looks to take advantage of the impulsiveness of individual investors. The best defense an investor can have against being negatively affected by manipulation is to understand the various types of these, and to be alert to their signals.

This article was written by

Richard Lehman profile picture
Adjunct Finance Professor at UCLA and UC Berkeley (18 yrs), author of three investment books, Wall Street veteran and founder of Informed Assets, PBC. Helping people understand and invest in equities, options, and alternatives such as Cryptos, NFTs, collectibles, private equity, real estate, venture capital, etc.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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