Friday, November 10, 2017

Manipulations in stock markets

Manipulation is nothing new in the stock markets but new tactics have evolved with technology enabling the use of algorithms. First of all, let us try to understand how manipulation works and  brings profits within a short term for those who set-up the game. Remember it is traders who are hurt the most and the long term investors the least in these plays.

  • Every trader has an expectation with the direction of stock he is trading. It could be bullish, bearish or sideways.
  • They have a trading plan too. Enter at some price, book profit at some price point or stop loss at a point when their trade goes wrong.
  • And there are a given number of traders in a particular stock at the given time.

The above information is enough for an algorithm to set-up a game. Let us say, in one particular stock, there are more bullish players. Let us assume 80% of the bets are on the one side and if it is a small counter, it is possible to manipulate the stock (for example, by buying puts, selling calls and heavy selling in cash market simultaneously). As spot prices drop, all of those traders playing bulls will be forced to get out of the market as their stop losses get hit. The manipulator uses few tens of crores on just one stock to take it below technical support level of the traders (as identified by the algorithms). He will make small loss in spot market but gains huge in derivatives. As he kills all weak traders, he gets out of that counter. Sanity check comes back slowly and the stock price comes back to normal levels. This is just one simple example but the algorithms can be set for multiple strategies to make money for those who employ them.

How do you know which stock is manipulated?

  • Look for very high OI on the option chain and Futures. As it reaches 100% of the limit, stock goes into F&O ban.
  • In the intra-day, you will see high price variations with low volume. And the reversal happens pretty quickly. This process repeats multiple times as a bait to attract traders and then put the short term traders into a trap.
  • Look for divergence from non-manipulative counters. Indices (like Nifty) and bigger stocks with a wide investor base (like Larsen, HDFC Bank) are not easy to manipulate as the manipulator need huge sums of money to manipulate and even if attempted there would be counter forces coming into play soon to restore the normalcy. In case of manipulated stocks, you will see an overreaction or divergence from broader market direction.

How do I survive now as a trader?

For human traders, it is not an easy thing to compete with algorithms. Psychological pressures will be very high to handle and the technical indicators seems to go wrong (as they are manipulated). So it best to avoid the counters once you identify the manipulations in them and stick to your trades in indices or with large cap stocks.

But if you are an experienced trader and have the ability to look at markets dispassionately, you would be able to understand what these algorithms are at since they are also devised by human beings. The key here is not to be emotional, wait patiently, do not get into devised traps and when the market seems to be not expecting a move, then you have a chance to go for a swing trade as those algorithms go out of action and you will have a chance to profit from it.

This opportunity does not come every day so one needs to wait until overselling or buying reaches an irrational stage and after that nothing seems to be happening for some time and it leads to volatility drop as one sided trades go awry. When the interest seems to be dead and a common person wonders 'what is happening with his stock?', the reversal happens. To time it and to know a price range to enter and exit, you need to understand fundamentals along with technical of that stock well along with market conditions and the changing investor profiles. It is really a hard game. As algorithms take the stock beyond fair levels on either direction, there lies an opportunity for a human trader to get into the game.

In summary, just being a technical trader, you cannot beat the algorithms consistently in the mid-cap or small cap stocks. It is better to focus on large cap stocks and indices. If you still want to trade in manipulated counters, keep your exposure limited. Do not just use support and resistances to enter a trade which worked earlier but no more, instead get a balanced view. You will begin to understand the master game being played.

Note: I do not mean all of algorithm trading is manipulative but I am of the opinion that it makes the manipulation easier.