Market manipulation comes in many shapes and forms, and it’s always prohibited. When a financial professional engages in an activity that artificially influences the price of a security, they manipulate the market. We’ll cover these specific prohibited activities in this section:
Painting the tape sounds nice, but it involves creating the false appearance of market activity. This is normally done with thinly traded stocks, which are easier to manipulate due to their lack of trading.
Assume a group of financial professionals picks a small penny stock to invest in. The group buys and sells the stock among themselves, which creates a significant amount of trading activity. An uptick in trading activity for a thinly-traded stock tends to gain the market’s attention, driving some investors to take a chance and purchase the stock. With more demand, the stock price rises. After the increase in price, the group sells and collects a profit. Painting the tape is sometimes referred to as matched orders or wash trades.
Marking the open or close is the act of placing trades prior to the market open or close solely to influence the price of the stock. A stock’s opening or closing price is very closely followed in the market. If a group of financial professionals colluded to place a bunch of orders right before the market opened, they could potentially manipulate the price upward.
If the stock were to open at a higher price than expected, it could increase demand. After the stock price increases, financial professionals could sell the stock for a quick profit. The same could be done at the close of the market. Either way it’s done, it’s prohibited!
This should be fairly intuitive, but spreading false rumors about a security in order to manipulate its market value in any direction is explicitly prohibited. Even if there are shreds of truth in the rumor, intentionally spreading misinformation in order to profit from a security should always be avoided.
Pump and dump schemes involve the intentional spreading of information (sometimes embellishing truthful information) in an effort to create additional demand for a security. Once the additional demand results in a higher market price, those who spread the information “cash in” by selling the security.
This type of market manipulation doesn’t occur rarely. The Securities and Exchange Commission (SEC) routinely prosecutes individuals and organizations for engaging in these activities (here are three examples - 1 2 3). Even 50 Cent (the rapper) was once accused of participating in a pump and dump scheme.
Free riding is a prohibited trading practice that occurs when an investor buys a security and sells it before making payment with settled funds, which violates Regulation T. If an investor fails to pay before selling the security, they are essentially using the broker’s funds to complete the trade without putting up their own capital. As a penalty, the brokerage firm must freeze the investor’s account for 90 days, during which all purchases must be fully funded in advance. While free riding is a violation in cash accounts, it is possible to avoid free riding violations in a margin account by using borrowed funds to cover purchases while waiting for sales to settle.
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