Wednesday, October 20, 2010

Stock Manipulation: Does the Average Investor Really Know What it is?

This piece was written by guest contributor Jennifer Gorton from Forex Traders:

The previous “Flash Crash” back in May and the resulting report from government authorities have done little to restore confidence in the investing public that the stock market is not a rigged game, controlled by the super-wealthy and manipulated at will. Mutual fund reports continue to report that for the past year or more the average investor has cashed in his stocks and moved everything into money funds, or worse yet, bonds. Most industry analysts view bonds as a ticking time bomb that will depreciate in value at the smallest hint of a Fed interest rate increase.

Are there really any true instances of market manipulation? Most assuredly yes, and this answer is not mere conjecture or opinion, but is actually supported on a day-to-day basis. In some cases, it is a pure necessity or there would be no market makers for small company stock issues. Every stock traded on an exchange must have a market maker that fulfills the responsibility for being the buyer of last resort. In the process of fulfilling this requirement, a broker may build up an inventory of stock, and then have to wait for an upswing in volume to unload. More often than not, the broker knows of planned favorable news releases and plans accordingly. Liquidity is typically lacking in small-cap stocks, but rumors and news can change that in an instant.

Although subtle manipulation may support micro issues, the process of manipulation generally falls more into the category of trading scams to be avoided. Owners of small cap stocks look forward to the day when short sellers get boxed in and owners refuse to sell, thereby forcing the short to buy at higher prices. However, the reality is usually an opposing scenario where a telemarketing operation circulates positive rumors to drive up a stock’s value artificially. If rumors did not produce the desired result, then churning and ramping from self-dealing can also increase demand and inflate a stock’s price. A “pump-and-dump” scheme is the inevitable outcome where the criminal unloads a large quantity of shares at a higher price to unsuspecting buyers that are left holding the bag.

Over the past decade, several unsavory types set up short-selling newsletters that blasted away on smaller firm offerings in the market. The shear weight and preponderance of their messages would drive even a medium sized firm’s offering price to the floor. These short selling companies and their owners made millions at the expense of general shareholders until the SEC stepped in and shut down these questionable operations.

The average investor prefers to believe in various conspiracy theories. When the SEC and CFTC combined report revealed that one wealthy investor’s poorly programmed trading robot caused the overload of false trading signals back in May, it only added fuel to the fire that large hedge funds and the clients they represent could achieve similar market responses but in a more controlled manner with less chance of suspicion.

Many investors have moved on to forex trading where the market is the largest and most liquid in the world. Even central banks have difficulty in manipulating this market. However, the fact remains that a forex broker must aggregate trades in order to offer retail forex trading in the first place, and in so doing, the manipulation of spreads is a foregone conclusion, almost a necessity of doing business.

Market manipulation is real, and at times, it does foster liquidity and aggregation benefits. However, a wise investor must be aware of potential trading scams and when they are most likely to occur.

VFC's Take:  I appreciate Jennifer's time and effort on this piece.  Definitely informative and well worth the read.

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