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August 13, 2010

Trad­ing today is mainly done by com­put­ers. Stock traders plug in “buy” and “sell” orders based on a spe­cific price. If the stock price rises above, or falls below a cer­tain point, the com­puter will auto­mat­i­cally buy or sell the stock. Some “Day traders” make, or lose, their for­tunes all the time using this tech­nique, and mutual funds, often too large to man­age by one per­son, also use this technique.

Know­ing how the mar­ket works is often a key to mak­ing money. Here’s a sce­nario where a hedge fund man­ager can manip­u­late the mar­ket to make a fortune…

Let’s say our Hedge Fund Man­ager has a port­fo­lio worth a bil­lion dol­lars (the actual amount doesn’t really mat­ter, but I picked it to illus­trate that you need some seri­ous resources to do this, it’s not for the aver­age guy). He decides to pick on a fairly well known com­pany Wid­gets Inc. (In this case think of Wid­gets Inc. like Microsoft, John­son & John­son, Coke, or some other well known company…I just didn’t want to use any real one in the exam­ple) which is usu­ally well traded and is owned by many mutual funds.

On an aver­age trad­ing day, Wid­gets Inc. is trad­ing at it’s nor­mal price of $20 +/- a few cents…a typ­i­cal day. Our crafty man­ager decides to make some seri­ous money on Wid­gets Inc. In order to do this, he needs to manip­u­late the price and get it to trig­ger the “Stop Losses” (the trig­ger point which causes com­put­ers to sell if the stock price drops below a cer­tain point). Now, when you con­trol a bil­lion dol­lars, a cou­ple of mil­lion doesn’t seem like much, so our man­ager decides to dump a cou­ple mil­lion dol­lars worth of Wid­gets Inc.

A cou­ple mil­lion dol­lars worth of shares, sud­denly for sale all at the same time causes the stock price to fall…the law of sup­ply and demand here, sud­denly there is a huge, uncom­mon, amount of shares on the mar­ket. The stock price goes down a cou­ple of dollars…A 10% value drop in a mat­ter of min­utes for a sta­ble com­pany is a seri­ous move…the “Stop loss”  point for day traders and mutual funds is tripped, flood­ing the mar­ket with even more shares of the com­pany and the price falls even further…triggering more stop losses, and the cycle keeps feed­ing itself until trad­ing stops for the day, when the stock closes at $10.

Just before the end of trad­ing, our man­ager picks up sev­eral mil­lion dol­lars worth of Wid­gets Inc. for half price, twice as many as he sold in fact. He did take a loss of 10% on his ini­tial 100,000 shares, but now owns 200,000 shares of the same company.

At the end of the day, the news is a buzz about Widget’s stock price, but noth­ing seems to explain the price change…someone in the press announces that there was spec­u­la­tion that the com­pany was going to lose a major con­tract, and that caused uncer­tainty in the market…of course Wid­gets Inc. quickly releases a press release say­ing that there is no truth to the rumour, and that it has indeed secured the contract.

As the mar­kets open the next day, traders scram­ble to buy up Wid­gets Inc. shares as there is no fun­da­men­tal rea­son why the price of the shares are so low, and in the next cou­ple of days the share price rises to $22 because of all the pub­lic­ity sur­round­ing the company.

At this point, our man­ager sells 100,000 shares for Wid­gets Inc. mak­ing back all his losses, plus 100% return on investment…while he enjoys his orig­i­nal invest­ment of 100,000 shares hav­ing gained a nice 10% profit as well. Not a bad day’s work. Of course all those gains are some­one else’s losses…

Of course, this exam­ple is grossly sim­pli­fied, and the SEC may inves­ti­gate any extreme case, but this tech­niques does occur and, if done on a small enough scale as to not draw too much atten­tion, is never investigated.

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