Investments

How Hedge Funds Manipulate Stock Prices

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 8 minute read

When you start trading stocks, you’ll do your homework on the firms you’re considering so that you can put your money to good use. But what if you find out that your findings are wrong? What if the price changes in the stock you’re watching were the product of deliberate market manipulation?

In a nutshell, your investment will be lost.

You may feel frustrated and angry with the stock market, the authorities, or even your brokerage. Maybe you’ll blame yourself and conclude the stock market is too risky for your money.

There’s little doubt that the real culpability rests with the manipulators, but there are things you can do to protect yourself from being a victim and to help your fellow stock market participants by reporting wrongdoers.

What Is the Definition of Stock Market Manipulation?

Stock market manipulation, in its simplest form, refers to the intentional manipulation of stock prices to either artificially inflate or deflate the market.

Suppose someone has 100,000 shares of XYZ stock that they acquired for $3.50 each. The typical investor would rather wait for a natural increase in share price and then sell at a time when they expect to earn the greatest possible price.

However, a person who manipulates the stock market would approach this situation very differently. Instead of simply waiting for share prices to rise, the manipulator may instead broadcast misleading information, promote rumors, or employ any number of other strategies.

It is common for manipulators to spread false information about alleged mergers, product debuts, or contract signings. On the other hand, in the realm of penny stocks, this sort of information might lead to gains in the multiples.

When the manipulator determines that share prices have climbed high enough, they will sell big blocks of shares at once for a profit, sending the stock price down and leaving other investors holding the bag with losses from which they may never recover.

Stock Market Manipulation Types

Manipulation of the stock market, like other cons, occurs in many ways. Stock market manipulators frequently resort to such cons as:

  1. Pump-and-Dump Plans

In the stock market, a pump-and-dump strategy is the most typical kind of fraud. This is the type of plan described above, in which the con artist purchases stock, spreads false information that drives up the stock price, and then sells at the peak to pocket the gains at the expense of the victimized investors.

  1. Promoters of Stocks

While promoting a stock is not technically unlawful, many investors view it as unethical and a form of manipulating the stock market.

Typically, the strategy begins with penny stocks when the company’s management concludes that the stock is cheap and has low liquidity. Some publicly listed corporations may employ stock promoters to boost prices and ease liquidity worries.

These advertisers receive hundreds of thousands of dollars in compensation. Stock promoters are paid to spread good information about a company or security over the Internet via blogs, social media, and discussion forums. The hope is that investors would experience FOMO (fear of missing out) and buy the stock after reading these overwhelmingly positive assessments.

If disclaimers are included on the content clarifying that it was paid for, then there is no legal issue. In contrast, stock marketing is widely frowned upon for two compelling reasons:

  • Change in the Short Term When a stock is promoted, its price and liquidity both rise in the near run. Investors who bought shares in anticipation of a promotion sometimes lose a lot of money after the campaign ends and the stock price drops back to where it was before the beginning of the promotion, or even lower.
  • Cash. Most firms that issue stock promotions are in need of capital. When companies need to obtain capital through the sale of newly issued shares, they often resort to promotion in order to drive up share price, which dilutes the value of current shareholders. In these situations, promotion is used as a backdoor method of charging individual investors for the company’s increased cash flow.
  1. False Information Dissemination

This is another instance of illegally manipulating the stock market. Scammers are not always deterred by the law; if that were always the case, there would be no such thing as fraud.

The reliability of data is crucial in the financial markets. After all, information about a publicly listed firm or its major shareholders might cause a substantial shift in the stock price.

The management of a corporation may try to cover up problems by releasing misleading information in a press release, SEC filing, or any other kind of public communication. Brokers who are aiming to make a commission on the selling of shares will also do this.

The stock price often rises when the incorrect information is disseminated to the investment community and picked up by regular investors. Increased trading activity is a positive side effect, but when rumors are debunked, the market usually reacts negatively.

The Enron crisis is a prime illustration of the devastation that may arise from the spread of incorrect information; many investors lost enough money in the scandal that they were unable to retire.

  1. Extreme Short Selling

Although technically allowed, shorting is controversial since it can cause long-term investors to lose money if there is a large volume of short sales on a certain company.

The practice of short selling is straightforward. If a trader anticipates a decline in a company’s price but doesn’t want to wait for it to happen, they can “short” the stock instead.

To borrow shares from other investors, the investor must go via a broker. The stock is then sold on the open market at the present price. In the event of a decline in the stock price, the short seller will purchase back the borrowed shares at a cheaper price and deposit them into the original account.

Even though short selling is perfectly legal and common in the stock market, massive coordinated shorting can cause a company’s value to plummet, resulting in heavy losses for anyone unlucky enough to get caught in the crossfire. In addition, short sellers may spread misleading information in an effort to drive down share prices and increase their profits at the cost of the investing public.

  1. Interest Rates Changed by the Federal Reserve

The U.S. Federal Reserve is a major stock market manipulator. Inflation and economic stability in the United States are entrusted to a private bank, and that bank is one of the most powerful manipulators of the stock market.

Federal funds rate is the benchmark interest rate at which commercial banks borrow cash and is set by the Federal Reserve. The stock market often improves and bull markets spread when the fed funds rate is low because more investors have access to the cash.

When the fed funds rate is higher, on the other hand, borrowing cash will cost you more and will be somewhat more difficult to come by. Consumers are less inclined to make large purchases like new houses or vehicles during these periods. As a result, many choose to retain their savings in the bank, where they may earn a greater interest rate. Therefore, market falls and typically broad bear markets follow a rise in the fed funds rate.

Not everyone is comfortable with the concept that central banks are actively influencing market prices. In truth, the central banks’ dominance over national economies and the stock markets that drive them gave rise to the concept of cryptocurrencies. There has been a surge of interest in Bitcoin and other decentralized cryptocurrencies due to the widespread belief that the world needs such a system.

What do manipulators gain from it?

Stock market manipulators gain for the obvious reason that it’s an easy way to make money quickly.

To continue with the aforementioned scenario, the manipulator paid $3,500 for 100,000 shares of XYZ stock. After acquiring stock, the manipulator will spread false rumors via email blasts, social media posts, and sponsored website articles claiming the firm is in acquisition negotiations with a major player in its industry.

The stock price might rise from $3.50 to $7.00 (or more) in the blink of an eye as the fake news spreads. Before the rest of the market is aware of what’s occurring, the manipulator starts selling shares for $7 apiece and quickly makes a profit of $14.

Astute investors will eventually catch on to the massive sell order, but by then it will be too late: once they discover the good news was fake, they will rush to sell their shares, sending the stock price tumbling back down to $3.50 or below.

These scams, known as pump-and-dump schemes, result in huge profits for the manipulator at the expense of gullible investors.

Who safeguards investors?

It is imperative that you take precautions against stock market frauds before doing anything else. To do this, you need to conduct thorough research and use the following guidelines. 

However, it’s not entirely up to you to guard yourself against con artists. The Securities and Exchange Commission (SEC) is a federal organization tasked with ensuring the smooth operation of the stock market.

After the 1929 stock market crash triggered the Great Depression, the SEC was established in 1933. Given the lack of regulation at the time, the stock market was ripe for fraud.

The U.S. government recognized the need to take action in response to the devastating financial impact of these frauds. The Securities and Exchange Commission was set up to prevent a repetition of the practices that triggered one of the most severe financial crises in history.

The SEC now routinely monitors the financial markets in search of fraudsters, punishing those who are found with monetary penalties, the return of stolen funds, and the prohibition of future employment or promotion in the securities business or in executive positions at publicly listed corporations.

Reporting Market Manipulation

Again, the SEC just doesn’t have the manpower to monitor the stock market constantly enough to prevent all fraud. Now you may play a part. When you, as an astute investor, detect a stench of fraud, you may help the regulatory body act on your suspicions. You may notify the SEC of any suspected securities fraud or other misconduct.

Remember that the Securities and Exchange Commission investigates misbehavior of all types. You may utilize the SEC’s website to report any stock market frauds you come across, including Ponzi schemes, high-yield investment programs, and pyramid schemes, protecting your fellow investors and the national economy in the process.

Bottom Line

Investors, in general, are wonderful individuals. They enjoy life, they make others laugh and they cause no damage to anyone. But there are bad actors as well, and so long as there are ways for them to earn fast money, the stock market will be manipulated.

If you follow the advice given above, you will be able to avoid falling victim to this deception by using information you have independently confirmed. By reporting fraud, you may safeguard the interests of other investors and the national economy as a whole.

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