Are stock prices random? A look at market structure

Just look at the highly manipulated chart below:


NXTH was a pump and dump scam.  I don’t know how insiders did it but the stock price was highly manipulated, as you can see by the chart above.  The idea was probably to sucker investors/gamblers into a stock that constantly goes up in a straight line.

Other stock market phenomena that cause non-random price movements

Getting listed on NASDAQ / pump and dump

There used to be a company called China Agro Sciences Corp.  It was probably a pump and dump scam.  (I don’t know whether or not it’s true, but it shouldn’t really matter.)  When the people behind it were done pumping and dumping, China Agro became a shell company.  Then the shell was taken over by a new team of people and the company eventually became China Hgs Real Estate Inc. with the ticker symbol HGSH.  These guys wanted to get listed on NASDAQ.  I believe one of NASDAQ’s criteria is a certain minimum stock price and market capitalization.  So insiders traded with each other to inflate the stock price.

Andrew M. Calamari of the SEC investigated the trading behind HGSH.  There is a document relating to his work which you can read here (5.4MB PDF)… there’s a lot of very interesting stuff in it.

Market making shenanigans and the flash crash

There is an excellent Wall Street Journal article that describes how market makers manipulate the opening price on a stock.  (Bright Trading, the website hosting the article, is a day trading firm that tries to capitalize on market inefficiencies like the one described in the WSJ article.)

Market makers can cause other inefficiencies as they will often manipulate the market price at other times of the day to screw over some retail investor who placed a market order.  This explains why there are often intraday jumps in an illiquid stock’s price.

Nowadays, the market has evolved into a situation which makes it extremely prone to flash crashes.  There are many parties who play the game of buying at the bid price and selling at the ask price.  There are various mechanisms which allow them to front run legitimate investors, giving these parties a trading advantage (it involves “sub-penny price improvement” and the rebate structure of exchanges).  They exploit this advantage to constantly earn a spread between the bid and the ask.  The problem is that market makers incur risk in doing so.  They may end up building up an inventory of stock they can’t get rid of.  When the proverbial excrement hits the fan, these market makers will need to cut their losses and close their positions.  They become forced buyers or sellers.  This can cause extreme movements in stock prices if they have huge inventories of stock that they desperately need to get rid of for risk management purposes.  This is my theory as to why the flash crash occurred.  When too many financial parasites suddenly need to dump their positions at the same time, it will lead to a flash crash.

Thomas Peterffy of Interactive Brokers has an amazing speech where he tells his industry peers that:

  1. They should probably stop screwing over their clients.
  2. The widespread practice of order flow internalization will ultimately contribute to more flash crashes, hurting the reputation of the industry in the long run.

He also makes a number of other comments on the structure of the current market.

Other causes

  • Financial bubbles like the Dot-Com bubble.
  • Short squeezes.  Volkswagen and CMEDY had interesting stock charts.
  • There are some financial markets where many participants use stop orders or barrier options.  This can cause unusual price movements as some traders may try to intentionally trigger stop orders or the barrier options.
  • Human beings do not choose numbers randomly or according to some computer algorithm.  People are more likely to input a buy order at round numbers like $10.00 than messier numbers like $10.23.  Stop orders may be clustered around particular numbers and technical resistance/support levels.

One thought on “Are stock prices random? A look at market structure

  1. Pingback: Order execution traps | Glenn Chan's Random Notes on Investing

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