Is It Possible – Or Legal – to Manipulate the Stock Market?

Whether the stock market is “rigged” can be a loaded question – one that the hyper-volatility of formerly-failing stocks such as GameStop and AMC Entertainment Holdings have us examining in-depth. While the SEC has rules that, in theory, are designed to prevent such occurrences from…well, occurring, such unprecedented movements reveal the cracks in the regulatory framework.

Furthermore, although the SEC exists to make trading as equitable as possible, it’s also inescapable that bigger players with deeper pockets inherently hold more sway over the market. And in fact, it’s this reality of market manipulation that the perpetrators of the GameStop saga claimed, at least in part, to protest.

First Off: What’s Up with GameStop?

GameStop has had more than one wild ride since the start of 2021 – but the first one is what has traders, brokers, and the SEC all a-tizzy. In January, a Reddit-based group of day traders used the subreddit WallStreetBets to promote GameStop through the roof. The stock climbed quickly, from around $20 per share to $65 – and then from $77 on January 25 to almost $350, its highest point ever traded, by January 27. All in all, the stock made a total 1,200% leap YTD.

A six-month view of GameStop, highlighting the stock’s unprecedented meteoric rise – and fall.

Image Credit: CNBC

By the next day, the stock had fallen to $193 before climbing again, and then once more plummeting. In the nearly two months since, the stock has experienced more turbulence as traders continue to harp on the “undervaluation” of GameStop stock. Despite the hype, however, GameStop hasn’t managed to breach that $350 overvaluation since January.

So, What’s the Controversy All About?

While it may seem that GameStop merely experienced an unprecedented short squeeze at the behest of a handful of Reddit-based traders, that’s not the entire story.

While Redditors were whipping themselves into a frothing frenzy over a beleaguered stock, a number of hedge funds, short sellers, and brokers (notably Robinhood) faced serious financial consequences as a result. In fact, Robinhood experienced such a squeeze that it halted trades of GameStop – as well as other “meme” and “undervalued” stocks such as AMC – citing concerns that they wouldn’t be able to post sufficient collateral at their clearing houses to execute orders.

And this is where the controversy kicks in.

As a business, Robinhood has obligations to its shareholders, Board of Directors, and clearing houses to maintain reasonable profits, pay its debts, and avoid bankruptcy. But as a broker, Robinhood also has a responsibility to provide market access and securities trades to all customers – not just wealthy clients and hedge funds. Thus, by cutting off traders from a stock soaring in price and popularity, critics argue, Robinhood prevented the Average Jane and John Doe from partaking in a chance to seek profits in a rapidly rising market.

Since this fateful move, Robinhood has faced both criticism and dozens of class action lawsuits from prominent politicians, lawyers, businesspeople, and traders seeking answers and financial restitution. The U.S. House Committee on Financial Services held a congressional hearing on the incident. And, although the future of this case is uncertain, the SEC is probing both sides of the aisle for signs of market manipulation: Robinhood and other brokers for cutting access to the market, and Wall Street Bets and other social media-based traders for artificially hyping a once-dying stock.

Which brings us to the pivotal question of our discussion.

What is Market Manipulation?

In 2018, Merritt Fox, Lawrence Glosten, and Gabriel Rauterberg wrote an article on stock market manipulation in the Yale Journal on Regulation. These three scholars – two members of Colombia University, and one of the University of Michigan – wrote that “manipulation may be the most controversial concept in securities law…. [It is] both under-inclusive and overinclusive in comparison to whatever is the ideal baseline.”

In other words, there is no good measure of manipulation in a system with so many moving partners and pieces. As a result, the legal system often appears to miss big players it will struggle to prosecute while homing in on smaller infractions it can successfully penalize on the public stage.

According to Investor.gov, market manipulation is when “someone artificially affects the supply or demand for a security” for personal gain. This “someone” may be an investor or group of investors, the issuing corporation, or a third-party scammer.

Technically, market manipulation is illegal. But some methods are difficult to track, and SEC regulations may be unclear on how to proceed in certain situations. (The GameStop/Wall Street Bets controversy is one such instance.)

Furthermore, some methods of manipulation may be unethical but technically legal, or both ethical and legal but ultimately inequitable. The ease of perpetuation – and level of success – often depends on how much trading power the entity in question maintains.

Unfortunately, individual investors are often the ones who suffer as the result of such activities. With the possible exception of Elon Musk, no one person (or at least, no typical retail investor) has the ability to sway the entire market on a whim…in theory.

So why does market manipulation still happen?

The Difference Between Manipulation and Regular Market Activity

When you invest in the stock market, your goal is the make money based off fluctuations in price. Day traders aim – and largely fail – to make their fortunes by trading securities as soon as prices move favorably. Some investors try to short stocks to make money off a company’s misfortunes. Value investors typically buy and hold securities in the hopes that its fundaments, combined with market action, will lead to profits over time.

All these methods share a common thread: discovering and exploiting legal opportunities for profit. By doing so, investors – and by extension into the business world, entrepreneurs – benefit themselves with profits, and society by correcting the price of assets and underlying valuables. Over time, this can improve market efficiency while lending everyone an opportunity to make a buck.

In market manipulation, however, the manipulator is attempting to sway prices from their accurate or earned positions. Instead of pouncing upon “naturally” under- or overvalued stocks, such perpetrators intend to create under- or overvalued stocks to make a buck. In the process, they deceive other investors to take part by purchasing or betting on their stocks – and leaving with the money before the bottom drops out of their false market.

As a result of their actions, manipulators directly profit at the expense of investors and corporations. This leads to poorer market efficiency, decreased societal benefits, and unstable economic security. Because a manipulator, by definition, manipulates the market into mispricing its goods, their actions are considered both unethical and illegal.

Types of Market Manipulation

There are literally dozens of ways to manipulate the market – we won’t cover all of them here. Instead, we’ll briefly define some of the more common schemes, each of which attempts to manipulate the market by at least one of the following methods:

  • Making securities appear more actively traded than they are
  • “Rigging” securities to look like they have higher or lower prices, trades, or quotes
  • Spreading misleading information about a company or its stock
  • Utilizing (accurate) information that is not publicly available to other traders

Insider trading is perhaps the most well-known type of market manipulation. This occurs when business deal or company insiders with confidential – and market-changing – information take advantage of their knowledge to make a profit (or avoid losses) by trading their shares.

Pump and dump schemes are another familiar trope. In these cases, an investor who owns shares of a stock spreads exaggerated or misleading information about the company to hype interest. When the share prices shoot up, the investor sells out, leaving everyone else to suffer losses.

Poop and scoop cases are far less common because they’re harder to pull off, but they do occur. In a poop and scoop, a manipulator spreads false information about a stock to convince investors to sell their hand. When the price drops, the manipulator goes all-in on the stock and rides the elevator to unearned profits.

Churning occurs when an individual places simultaneous buy and sell orders at the same process at different brokers. The purpose is to “churn” up the trade volume so that stocks appear more interesting, thereby increasing the price as everyone piles onboard.

Of course, it’s possible to manipulate the market legally simply by exerting power. One example of this is the slingshot effect, where a large institutional investor dumps its position in a stock overnight. As a result of the sudden uptick in activity, the price drops, and the institution can later buy back their position at a fraction of the selling price. (We’ll give an example of this below).

Additionally, there are times when an individual investor, such as Elon Musk, engages in manipulative activity without the burden of proof – defined by the SEC as intention to deceive or defraud – needed to count as illegal activity. Such actions include:

  • Expressing a genuine belief about a company or stock
  • Unintentionally excluding relevant data when you publicly argue your position
  • Urging others to adopt your views on a particular security
  • Making unintentionally mistaken assertions

Cases of Market Manipulation that Made History

While market manipulation is notoriously difficult to track and prove, there have been a few high-profile cases of manipulation in the last century. And, while we’re happy to say that many mega-manipulators get their comeuppance, unfortunately, there are at least a handful who don’t.

History’s First: Michael Meehan

Michael Meehan (right)

Michael Meehan was an English-born stock trader who rose to prominence in the 1920s and ’30s. While his name may not ring a bell to some, those in the financial industry recognize him as the first person to be prosecuted by the SEC.

Meehan got his start as an investor in the Good Humor ice cream company as a favor to an old friend. When the market crashed in 1929, the company stayed strong and paid high dividends – leading Meehan to purchase a controlling stake in the company. This helped catapult his early fortune, which he used to purchase seats on the New York Curb Exchange – and later, the New York Stock Exchange.

Meehan’s controversy began in 1935 when he set forth plans to intentionally elevate the price of Bellanca Aircraft to make his fortune (again). He began to churn the market, placing same price buy and sell orders to artificially inflate trading volume. Within months, other traders followed Meehan’s lead, and the price of Bellanca rocketed from $1.75 to $5.50 per trade – big money in those days. As soon as Meehan felt the price had peaked, he cashed in his shares…and the bottom fell out of Bellanca immediately.

Unfortunately for Meehan, the newly formed SEC (officially codified on 6 June 1934) was chomping at the bit for a high-profile target to punish amidst the tumult of the Great Depression. The SEC used their power, outlined in the new Securities Exchange Act, to expel Meehan from his positions on the NYSE, the Curb Exchange, and the Chicago Board of Trade.

Michael: Milken the Market

Michael Milkin

Michael Milken is another big name in financial circles due to his rule in developing the high-yield bond (junk bond) market. He is also at the heart of one of the most famous racketeering and insider trading cases of the 1980s.

Milken got his start in the investment market at the old-line investment bank Drexel Harriman Ripley in 1969. He was a natural in the field, boasting only four down months over the next 17 years. As a result of his natural prowess, he convinced his bosses to let him begin trading in high-yield bonds – an investment that eventually turned a 100% profit and earned him the nickname Junk Bond King.

Due to his massive success, Milken was under constant SEC scrutiny. While there is some debate over how much of his behavior was unethical versus illegal, Milken was known for turning a profit on “novel” market moves, which set him in the SEC’s sights.  But it wasn’t his partiality to junk bonds that fell him – it was another infamous name: Ivan Boesky.

In the 1980s, Ivan Boesky was facing heat from the SEC due to multiple instances of insider trading. When he pled guilty to securities fraud and turned informant, he threw Drexel – and Milken – under the bus for a wide range of illegal transactions, ranging from stock manipulation to fraud to insider trading. The final blow to Milken came when Drexel lawyers discovered that Milken was both self-dealing in and bribing money managers with stock warrants through a secret limited partnership under Milken’s name.

While the SEC eventually indicted Milken on 98 counts of racketeering and securities fraud (and officially convicted him of six), he pled out of sentences on racketeering and insider trading charges. As a result, he paid $600 million in fines, served two years in prison (on a ten-year sentence), and was permanently barred from the securities industry.

Does This Make the Stock Market “Rigged”?

While these cases are two of the most famous in U.S. history, they’re by far the only instances of securities fraud on the books. And unfortunately, though many big names eventually are caught, there are most certainly cases where the evidence is too weak to prosecute in court – if the perpetrators are ever found at all.

This discrepancy in market manipulation versus criminal indictments often leads investors to ask a hard question: is the stock market rigged?

The short answer is no, the stock market is not rigged to give any individual persons a cheat. After these – and many other high-profile cases – made the books, the SEC put in place rules designed to provide all investors an equal shot at making their fortunes. However, that doesn’t mean that there aren’t disparities that make distinguishing between inequality and illicit activity difficult.

Inequalities in the Market: An Example

Let’s give an example. Say that BigCo is an institutional investor with a large position in Amazon stock. Thanks to their team of financial analysts, they predict that the stock is massively overvalued. So, to circumvent potential losses (and perhaps see gains in the meantime), BigCo dumps thousands of shares at once.

By flooding the market with Amazon shares, the price drops tremendously. Other investors, worried about the unexplained uptick in activity, get rid of their positions as quickly as possible, further driving down the price. Within a month, this brings Amazon’s shares significantly lower than market value – so BigCo makes a business decision to snap them up as quickly as possible. In turn, this drives the price back up, which moves hundreds of retail investors to dive back in while the gettin’s good. Eventually, the stock skyrockets to overvaluation once more, and BigCo dumps their position to start the slingshot cycle all over again.

As this move isn’t illegal, it’s relatively common in the stock market. Just as a retail investor has every right to buy and sell shares on legitimate beliefs, so do institutional investors. However, because of the sheer volume of shares moving at once (and because a single retail investor is unlikely to own enough shares to kickstart such a profitable chain of events on their own), this can give the impression than an institution is “rigging the market” – when in fact, it’s a business making a common-sense business decision to take advantage of their legally-held position.

Other Inequalities in the Market

Our BigCo example shows a specific, common situation that can give the impression of rigged game. But of course, it’s not the only way that markets tend to favor deeper pockets.

For instance, many corporate-sized investors have access to technical experts, experienced traders, and research analysts. While there’s a wealth of data online that the average investor may access, a single person has much less in the way of manpower to find and apply it. And alongside this knowledge excess – and people to process it – appears a seemingly bottomless pocket to buy and sell larger amounts of securities, which inherently influences the market more.

All this to say: there are many instances where it seems like the market is rigged against the little guy. And while the market is not actually rigged, the nature of economics lends itself to favor wealthier investors. Thus, smaller investors often have to overcome greater hurdles to make their riches.

How to Avoid Market Manipulation

Fortunately, the internet has been something of an equalizer for retail investors. While the wealth disparity is a subject for another day, the internet has made it possible for the average investor to access important data, allowing them to make timely, better-informed decisions.

And though the market isn’t rigged by definition, manipulation – legal and otherwise – still occurs from time to time. As a savvy investor, it’s up to you (and your financial advisor) to spot manipulative movements and avoid actions that will lead to your financial downfall.

One of the more proactive steps you can take is to carefully examine low-volume, microcap, and penny stocks before you invest. Due to less watchful eyes and, in some cases, relaxed trading regulations, these stocks are more susceptible to pump-and-dump and churning schemes.

For similar reasons, it’s ideal to avoid day trading. While making a few pennies per trade can add up in the long run, you’re also more likely to fall prey to market schemes based on rumors or falsely inflated numbers. Taking the time to vet your purchases – and your sources – before investing is the best defense against bad information.

But perhaps the best thing you can do to sidestep manipulative practices is to design a financial plan and stick to it. In very well- or poorly-performing markets, you may often feel pressure to deviate from your goals to avoid short-term pitfalls or ride the wave to riches. But more often than not, waves crash and slumps even out, and you’re left in the same – or worse – position than if you had maintained your course.

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