Market manipulation is nothing new and has been around for as long as markets have existed. Most methods rely on shifting perceptions about the marketplace, such as trade volumes, demand and supply on the order books, and other key determinants. Nevertheless, today’s increasingly complex computerized markets allow for new and innovative methods of market manipulation. Because of the fast pace of innovation and sometimes overwhelming complexity behind trading activity, regulation has at time lagged behind.
Below are some explanations of different forms of market manipulation, and what has been done to address these behaviors.
Spoofing & Layering
Spoofing is a strategy whereby one places limit orders, and removes them before they are executed. By spoofing limit orders, perpetrators hope to distort other trader’s perceptions of market demand and supply. As an example, a large bid limit order could be placed with the intention of being canceled before it is executed. The spoofer would then seek to benefit from prices rising as the result of false optimism others would see in the market structure.
More controversial has been the act of layering which carries many similarities to outright spoofing, but differs in that orders are placed evenly across prices with the goal of reserving an early execution priority at each given price level. If the person has no trade to execute at that price point the orders are simply removed. Despite being more benign in nature, the act of layering also distorts market demand and supply perception.
Spoofing and layering has been made expressly illegal in the United States under the Dodd–Frank Wall Street Reform and Consumer Protection Act, and has been actively prosecuted. Perhaps the most famous case of spoofing to date has been the recent arrest of Navinder Singh Sarao, in direct connection to the 2010 Flash Crash.
On April 21, 2015, five years after the incident, the U.S. Department of Justice charged Navinder. He was found to have used a lightly modified version of commercially available trading software to place orders and cancel them in rapid succession from his suburban London house. The orders were worth $200 million and were replaced or modified 19000 times before being canceled. These actions largely contributed to the “Flash Crash”, where the Dow Jones industrial average lost 9% within minutes, before gaining back it’s losses.
Unlike layering, where the high-frequency trader is seeking to ensure execution priority in the order book queues, quote-stuffing traders are thought to send in rapid orders and cancellations with the expressed purpose of slowing down. Indeed in research conducted by Nanex, it was found that by placing a large number of quotes in any one stock, it is possible to create latency across all stocks of the NYSE. This would allow a party the power to generate latency on demand. When 6,000 replacement orders for one stock are crammed into a second, each order is valid for less time than it takes for the news of the order (traveling at close to the speed of light) to reach anyone not at the exchange; no normal person can execute a trade against the phantom order, because it simply is not valid long enough.
The confusion arises when one begins to consider who would benefit from such actions. Those equipped with the high speed technology to engage in quote stuffing only stand to suffer, as they would also see their trades slowed. If anyone can be suspected of intentionally clogging up the lines (a market manipulation), the natural trail leads to low-frequency culprits unequipped with fast technology, for whom such manipulation may indeed result in increased profitability.
Unfortunately, some exchanges also profit by selling higher-capacity feeds to HFT traders, which disincents self-regulation that could prevent the quote stuffing.
Although it was found that 74% of U.S. listed equity securities received at least one quote stuffing event during the 2010 Flash Crash, so far persecution of this type of market manipulation has not taken place
Momentum ignition is a strategy in which a trader aims to cause a sharp movement in the price of a stock by using a series of trades, which indicate patterns for high frequency traders, with the motive of attracting other algorithm traders to also trade that stock. The instigator of the whole process knows that after the somewhat “artificially created” rapid price movement, the price reverts to normal and thus the trader profits by taking a position early on and eventually trading out before it fizzles out.
To detect momentum ignition, it is important to focus on the following three main characteristics as shown in the chart below:
1. Stable prices and a spike in volume
2. A large price movement compared to the intraday volatility
3. Reversion to the starting price under a lower volume
Credit Suisse estimated in a study that momentum ignition occurred on average 1.6 times per day for stocks in the STOXX 600 during the third Quarter 2012, with almost every stock in the STOXX600 exhibiting this pattern on average once a day or more. Moreover, the average price move is about 38 basis points but over 5% are more than 75 basis points, with some significantly higher, and the time it takes for that move to occur is approximately 1.5 minutes. While 38 basis points may not sound like a big move, it is a bit more significant when compared to the average duration of about 1.5 minutes and the average spread on the STOXX600 which is approximately 8 basis points.
Pump & Dump
Traditionally, a Pump and Dump scheme is implemented by fraudsters who try to inflate the price of a security by making false or misleading statements with regard to its value, usually via cold calling or by spreading fake press releases. These traders, who had accumulated a large holding in the security before initiating the “pump” phase, liquidate their position as prices rise, giving birth to the “dump” phase, in which the security usually ends up erasing its previous gains, inflicting massive losses on the late joiners of the “pump” phase. More recently, Pump and Dump strategies have often been adopted by high frequency traders, who create algorithms to momentarily drive up the price of a security, only to promptly reverse their position and capitalize on false momentum at the expense of other traders.
The most frequent victims of pump and dump manipulations are micro and small cap stocks, which due to their small trading volumes tend to be the easiest to manipulate. Moreover, it’s harder for most investors to assess the real value of these companies since they are relatively unknown to the public and not covered by research analysts, and thus information concerning their fundamental value is hard to find.
The flip side of the Pump and Dump is known as the Bear Raid, whereby a trader artificially depresses the price of a security, only to close his position at a profit at the first opportunity, all while leaving other investors in the dust. To put downward pressure on the share price the fraudster would usually spread negative rumors about the target firm, and this process has been made easier by the advent of the internet which helps spreading the rumors faster and wider. Both the Pump and Dump and the Bear Raid are typically considered a form of securities fraud.
Although the examples above only provide a glimpse of the many forms of market manipulation, it is clear to see that these are real all world phenomenon that take place actively on markets. Even more troubling perhaps is that the most innovative forms of manipulation are yet to be properly understood or regulated. Furthermore, although high frequency hedge funds are often the subject of much criticism when it comes to market manipulation, many methods stated have already been deemed illegal long ago by regulators, well before the advent of high frequency trading. Nevertheless understanding when market manipulation is taking place, and being able to avoid it is a skill any successful modern trader should possess.
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