Manipulation of a Stock

A company may be listed in the stock market for many reasons, but the most important of all, invariably, is to make money for the large shareholders. The shares of a company are usually worth a certain value, but until someone is willing and able to buy them from the holder, they remain a paper asset that cannot be converted into actual cash. By listing the company in the market, it provides a channel for the shareholders to openly distribute their shares to the public. In other words, a large shareholder of a newly-listed company is not very different from a shopkeeper with a full house of inventory: they both want people to come and buy their stock as soon as possible.

And just like other marketing campaigns, it takes good advertising for a company to attract buyers for their shares. This is why you see analysts recommending companies in television, and brokers giving tips to their clients whenever they call them. However, none of this propaganda would work if the share price of the company does not go up, because it is hard to attract buyers when there is no action. People usually come to the stock market for quick riches, and they seldom have the patience to sit and wait for something to move.

On the contrary, if the shares are acting strongly, then the world will happily talk about the company without anyone forcing them to do so. The press wants to print interesting stories, and interesting stories are usually composed of shares that keep making new highs. Reporters and bloggers will soon look into the financial statements and press releases, and write about all kinds of possible reasons for the increasing share price, because this is what their readers want to know. Since one can achieve all these great promotional effects by simply driving the price up, it is no exaggeration to say that a rising curve is the most effective of all propaganda in the stock market.

According to Lefèvre (1923), in the early twentieth century, there was a steel company which was listed in the U.S. stock exchange. Although it was a fundamentally sound company, its shares remained unpopular. It was the kind of shares that didn't go down because nobody sold them, and didn't go up because there was no incentive to buy them either. No one would like to tie up their trading capital in a lifeless market as comatose as a corpse. As a result, seventy percent of the shares remained undistributed after a very long time.

The underwriters of the company's shares knew that they had to do something. They had to create a market that could induce more buyers so that they could dispose the undistributed shares at a higher price. They deliberated over the matter and decided that they need a stock market veteran to help them out. After some discussion, they sent a representative to seek help from the most prominent speculator of their time: Jesse Livermore.

Livermore told the representative that he needed to think it over and he would get back to them in a few days. He usually had to consider two conditions before undertaking any job of market manipulation. The first condition was whether it was the right time. If he had to run up the share price of a company, he would prefer to do it in a healthy bull market. It is obviously not a very wise idea to boost shares in a bear market because no one would buy them. When the steel company's people approached him, the market was trending up in general, so the first condition was met.

The second condition was that the company must be fundamentally sound. A company with horrible earnings and lousy management could never sustain a high share price for a long time. Livermore sent some experts over to the various departments of the steel company to check how the company was doing. After some examination, the experts got back to him and reported that it was a valuable property, and the shares deserved to be priced higher in consideration of what they had found. This finding convinced Livermore that driving up the share price of the steel company would be fundamentally justified, so he told the representative that he would take the job.

After negotiating the terms with the underwriters, Livermore started working. When it came to market manipulation, there was a rule that Livermore always followed: one shall drive the share price up as high as possible, and then distribute the shares on the way down. The first step of his manipulation was to buy all the shares for sale in the market and drive the price to a new high. Remember, until that time the shares had been quite dead and not moving at all. This newfound activity got the attention of other speculators, who would think that some large buyers were accumulating the shares of the steel company, and naturally they followed suit and bought some for themselves too.

When Livermore saw the buying orders coming in, he happily met the demand of those buyers by feeding them the shares he had just accumulated. After those buying order were filled by Livermore, the advance of the price would come to a halt, and it would inevitably fall as some of the impatient traders sold their shares for a quick profit.

After the share price dropped back to a certain level, Livermore would step in to buy the shares sold by the other traders, and drove the price up again. After that, it was just repeating the process: buyers came back in, Livermore sold shares to them, then buyers took profit, and Livermore bought the shares once more. After this was done enough times, a large number of sellers would be eliminated from the market, and Livermore would now be able to rush up the share price to a brand new high.

As the price kept making new highs, it got more attention from the public. Those who seldom paid attention to the stock market would also start to hear about the steel company, and they would start to believe in the company too. It was the time when the brokers would call their clients and urge them to buy the shares. “Mr. Smith, how come you missed the whole move when the price was still low? Don't worry, though. If it could go up so many points so quickly, there will surely be a lot more upside. What are you waiting for? Go buy some shares right now!”

As the price kept making new highs, it got more attention from the public. Those who seldom paid attention to the stock market would also start to hear about the company, and it was when the brokers would call their clients and urge them to buy the shares. “Mr. Smith, how come you missed the whole move when the price was still low? Don't worry, though. If it could go up so many points so quickly, there will surely be a lot more upside. What are you waiting for? Go get some shares right now!”

As the crowd got overconfident and no longer feared that they might be buying too high, it was Livermore's time to sell. The way he unwind his position was exactly the same as what he did at the beginning: he sold on rallies and bought back at a lower price, yet this time he would sell more than he buy on balance, so that he would be gradually getting rid of his position until he had sold it all.

In the end, Livermore not only managed to sell a large number of shares to the public, but also earned himself a tidy sum of money as a result of his successful operation. For an individual speculator, the lesson of this story is that it is a very dangerous idea to buy the shares of a seemingly good company during a pullback, because the manipulator may have already started to distribute the shares, and the price may go a lot lower. As Livermore (1940) wrote in his book:

“When a stock starts sliding downward, no one can tell how far it will go... never buy a stock because it has had a big decline from its previous high. The likelihood is that the decline is based on a very good reason. That stock may still be selling at an extremely high price – even if the current level seems low... I become a buyer as soon as a stock makes a new high on its movement after having a normal reaction. The same applies whenever I take the short side, because I am following the trading at the time... I never buy on reactions or got short on rallies.”

Reference:
Lefèvre, E. (1923). Reminiscences of a Stock Operator. New York: George H. Doran Company.
Livermore, J. L. (1940). How to Trade in Stocks: The Livermore Formula for Combining Time Element and Price. New York: Duell, Sloan & Pierce.