What stock is selling recently and its gains

How big financial market players manipulate stock market prices

For some time now, the stock exchanges have been vulnerable to price manipulation. This fact can cost private investors a lot of money.

An unhealthy financial system encourages price manipulation. This connection was revealed in the last few days by the Japanese company Softbank. Softbank has pursued an extremely aggressive strategy in the past few months, which many blame for the mini-crash in the first two weeks of September.

For an explanation it is helpful to first deal with the expression “pump and dump”, for example “inflate and sell”. This approach is often used in illegal because fraudulent stock transactions with low-market values. The term “market values” means that the supply for the corresponding shares is small, so that even small changes in demand affect the share price. The procedure can be divided into four phases:

  1. «Pre-Pump»: Before the share price is artificially inflated, the manipulator buys up a large amount of shares in the selected company. Because it is a value close to the market, this can already cause the price to rise a bit.
  2. "Pump": The pump phase is about enticing gullible investors in sufficient numbers to also invest in this value. An often effective means of triggering these purchases is through email containing enthusiastic and untrue statements about the company's future profits. Some private investors are skeptical at first and want to wait and see, but then they see the price rise due to increasing demand (there are always some gullible investors who strike immediately). They take this slight price increase as evidence of a good investment, their skepticism evaporates. Such psychological mechanisms can lead to a veritable avalanche of buying with ever higher prices.
  3. "Dump": If the prices have risen sharply, the manipulator sells its shares for a hefty profit.
  4. “Post-dump”: sooner or later the price increase collapses and is reversed, with most investors making heavy losses.

Price manipulation is not necessarily illegal

The illegality of a pump-and-dump procedure results primarily from untrue or misleading statements in the pumping phase. But untrue statements are not necessarily necessary in order to trigger a price increase and thus an avalanche of desire to buy. Softbank's strategy has revealed to the public that this is also possible with legal means.

It is worrying that pump-and-dump manipulations are no longer restricted to small market niches and exotic small caps. The stocks of superstar companies such as Google or Tesla serve as the vehicle for the manipulation.

The simplest way how a manipulation takes place is as follows: A large player has enormous liquid funds or procures them cheaply on the credit markets. With this he buys shares on a large scale in order to “pump up” their price. Thanks to the enormous amount of money that he can use, he succeeds in doing so.

External investors see this price increase and see it as a sign that prices will continue to rise. They don't want to miss this expected price increase, so they buy shares. In this way, external investors ensure that their assessment is correct in the short term and that the price continues to rise, which attracts more investors. The initiator of this upward movement ultimately sells for a profit.

In order for the described process to be possible, however, certain requirements must be met. Manipulators can only make a profit in this way if the price effect is greater when buying than when selling. If the external investors react symmetrically to rising and falling prices, the manipulator earns nothing.

The manipulators solved the size problem

There is also a practical problem. The volumes in the stock markets may be too big even for a top player. Softbank has apparently invested at least $ 4 billion in its strategy, but not 20 or 30 billion. However, in order to move large stocks decisively, funds of this magnitude are probably necessary. So Softbank found another option, and the business likely went like this.

First, as in any pump-and-dump operation, the Japanese company bought the shares of the companies whose share price it wanted to pump up. These stocks included Amazon, Google, Microsoft and Tesla in particular. But Softbank also bought options on these stocks on a massive scale. Initially, this only increased the price of these options.

However, rising option prices can trigger a number of positive feedback loops. One of these feedback loops runs through the market makers of the traded options (market makers are large financial market players who make liquidity available to the exchanges). When option prices rise, the market makers' risk increases and they must hedge against that risk.

You can do this by buying the stocks that make up the underlying value of the options. For example, if Softbank has bought Tesla options and the price of those options rises, market makers buy Tesla stock to hedge. As a result, the price of Tesla shares rises, which affects the option price and drives it up, which in turn triggers further share purchases.

The clever thing about Softbank's strategy was to use this and other mechanisms to indirectly, i.e. via appropriate options, drive up the share prices of large companies such as Amazon, Google and Tesla. When the share price had risen sharply, Softbank sold the shares at a profuse profit.

Price manipulation can succeed even if a company only uses a few billion (and not dozen or so). Because options are leverage products. To put it simply: If Softbank bought options for $ 4 billion with a leverage of 10, the market makers had to buy shares for $ 40 billion for hedging. This should be enough to move the courses even for Google and Amazon.

The health of the financial markets is badly damaged

The question arises: Why is this type of price manipulation possible in the financial markets? This is because the financial markets are very far from a healthy balance. If prices were still largely anchored in company fundamentals, this would make the current upward explosion in prices much less likely. But share prices are now largely dependent on the liquidity injections from the US Federal Reserve, as well as on its other price support measures.

On the one hand, however, these Fed measures increase the number of trend followers in a market (because fundamental factors become less important), which intensifies price movements. On the other hand, there is an increased risk of short sellers who could contain excessive prices. Short-selling with the central bank as an opponent is not a promising business. And the Fed openly says that it will only tolerate exaggerated stock prices and intervene if prices are to decline to a more reasonable level - relative to the fundamentals. No wonder the stock markets are euphoric despite the pandemic.

A manipulated crash cannot be ruled out

Corrective and moderating influencing factors have lost an enormous amount of importance in recent years. This development has worsened again in the last six months, in particular due to the measures taken by the Fed. But such an unhealthy financial system encourages exaggeration and market manipulation. It is very unlikely that only Softbank will rely on the escalating herd behavior on the stock exchanges to manipulate prices.

This creates a very worrying circumstance for investors. There is not only the “pump and dump” manipulation strategy, but also one called “short and distort”. The point is not to drive the prices up, but to let the prices crash. The longer the prices stay high, the more attractive price manipulation that could trigger a crash could become for some of the big players.

The current state of the stock exchanges suggests that investors will have to expect numerous smaller or larger crashes in the near future. Volatility will remain high, especially until the US presidential elections. In view of the unhealthy markets, the increasing volatility and the increasing risk of possible short-and-distort manipulations, one thing is clear: long-term buy-and-hold investors should continue to be very defensive.