Stock Market Manipulation and How You can Avoid it

The stock market can be influenced by a variety of factors, including supply and demand for individual stocks, economic indicators, company earnings reports, and investor sentiment. A report published by the New York Attorney General’s office in 2013, titled “Virtual Markets Integrity Initiative,” estimated that 20% to 30% of all trading volume on U.S. stock exchanges was due to manipulative practices. When people refer to the market being “manipulated,” they usually mean that large institutions and designated brokers are using their power and resources to artificially inflate or deflate stock prices for their own benefit, often at the expense of smaller investors.

“The stock market is rigged. It’s rigged for the benefit of a few select players on Wall Street.”

Bernie Sanders, US Senator

There are several ways in which this manipulation can occur. One common tactic is known as “pump and dump,” in which a group of investors will buy up a large quantity of shares in a particular company and then use various tactics, such as hyping up the stock in the media, to create artificial demand and drive up the price. Once the price has reached a certain level, the group will then sell off their shares at a profit, leaving smaller investors holding the bag as the price falls back down to its original level.

Despite laws and regulations aimed at preventing market manipulation, it remains a persistent problem that contributes to rising income inequality. Large institutions and designated brokers often have more resources and information than individual investors, and they may be able to use that advantage to exploit market inefficiencies and take money from the working class. However, not all large institutions engage in such practices, and there are many reputable investment firms and funds that operate ethically and work to create value for all investors.

“The stock market can be so irrational at times that it seems almost an experiment in which the market manipulators are trying to determine how much lunacy investors can stand.”

Joseph Stiglitz, Nobel laureate economist and professor at Columbia University

There are many different ways in which the stock market can be manipulated by entities such as large institutional investors, designated brokers, and even the companies themselves. Here are some details on how this manipulation can occur.

Insider Trading: As mentioned earlier, insider trading occurs when individuals with access to non-public information about a particular company use that information to make trades that benefit them at the expense of other investors. This can include executives, board members, and other individuals who have privileged access to information about the company’s financial performance, strategic plans, and other important details. Insider trading is illegal, but it can be difficult to detect and prosecute. The U.S. Securities and Exchange Commission (SEC) has brought hundreds of insider trading cases in recent years, resulting in significant fines and penalties for individuals and firms involved. In 2020, the SEC obtained more than $600 million in financial remedies in insider trading cases, and has obtained over $4 billion in insider trading penalties over the past decade.

Market Making: Market makers are designated brokers who help to facilitate trading in a particular stock by providing liquidity and buying and selling shares as needed to maintain an orderly market. However, some market makers have been known to use their position to manipulate stock prices by engaging in practices such as front-running (buying or selling shares ahead of large trades to profit from the price movements), or by artificially inflating the bid-ask spread (the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept). Some market makers have been accused of engaging in manipulative practices, such as artificially inflating the bid-ask spread or front-running trades. For example, in 2020, a major market maker agreed to pay $65 million to settle charges that it misled customers and engaged in manipulative trading practices.

High-Frequency Trading: High-frequency trading (HFT) is a type of computer-based trading that uses algorithms to analyze market data and execute trades at very high speeds. HFT has been criticized for its potential to contribute to market volatility and create instability, as well as for giving an unfair advantage to large institutional investors who have the resources to invest in HFT infrastructure. According to a report from the International Organization of Securities Commissions (IOSCO), high-frequency trading accounts for a significant and growing portion of trading activity in many markets around the world. In some markets, HFT can account for up to 50% of trading volume.

Dark Pools: Dark pools are private exchanges where investors can trade large blocks of stock anonymously. While dark pools can offer benefits such as reduced transaction costs and improved liquidity for large trades, they can also be used to facilitate illegal insider trading or other forms of market manipulation. According to a report from the Financial Industry Regulatory Authority (FINRA), dark pools account for a significant and growing portion of trading volume in many markets. In the U.S. equities market, for example, dark pools accounted for about 15% of trading volume in 2020.

Stock Buybacks: As mentioned earlier, companies can use stock buybacks to boost share prices in the short term. By repurchasing shares on the open market, companies can reduce the supply of shares available for trading, which can drive up the price. However, this can also contribute to rising income inequality by enriching executives and shareholders at the expense of employees. According to data from S&P Dow Jones Indices, U.S. companies spent a record $806.4 billion on stock buybacks in 2018. While not all buybacks are necessarily manipulative, some analysts have criticized the practice as contributing to income inequality and favoring shareholders over other stakeholders.

While market manipulation does occur, it does not mean that the entire market is being manipulated. It is still possible for small retail investors to invest in the stock market and achieve long-term growth, but it requires diligence, patience, and discipline. Here are some strategies that small retail investors can consider to avoid market manipulation:

• Invest in index funds or exchange-traded funds (ETFs): By investing in index funds or ETFs, you can gain exposure to a broad range of stocks and markets, without having to pick individual stocks. Index funds and ETFs are typically less susceptible to market manipulation because they track an entire market or index, rather than individual stocks.

• Avoid “pump and dump” schemes: Be wary of penny stocks or other investments that promise quick and outsized returns. These types of investments are often promoted through unsolicited emails or social media posts, and are designed to artificially inflate the price of the stock before the promoters sell their shares, leaving small retail investors with losses.
• Do your research: Before making any investment, conduct thorough research on the company and the market in which it operates. Look for publicly available information such as financial statements, news articles, and analyst reports to help inform your investment decisions.

• Diversify your portfolio: One way to reduce your exposure to market manipulation is to diversify your portfolio across different sectors, asset classes, and geographies. This can help to reduce the impact of any individual stock or market on your overall returns.

• Use limit orders: When placing trades, consider using limit orders rather than market orders. Limit orders allow you to specify the maximum price you are willing to pay for a stock, or the minimum price you are willing to accept for a sale. This can help to protect you from price fluctuations that may be caused by market manipulation.