Wednesday, May 8, 2013

How to spot (and avoid) market manipulation

We often hear investors complain of financial markets (and the gold market in particular) being “rigged” or manipulated.  The sad yet somewhat humorous tale of Henry Gribbohm recently brought this accusation to life.  The 30-year-old Gribbohm infamously lost his life savings of $2,600 on a carnival game in an attempt at winning an Xbox Kinect valued at $100.  For his efforts, he walked away with a giant stuffed banana sans his $2,600 life savings.

Gribbohm’s tale is instructive if only because it reveals a common psychological pitfall that has plagued all of us at one time or another, viz. the desire the “win back what I lost” from the market.  According to news reports, Gribbohm attempted to win a ball-toss game at a traveling carnival but quickly lost $300.  He then returned home to get $2,300 more in hopes of winning back the lost $300 and –hopefully- the prize Xbox.  After losing everything he accused the carnival of rigging the game (sound familiar)?  (The game owner actually did end up refunding $600 of his $2,600).

Had Gribbohm been thinking clearly he would have cut his losses after his initial loss.  Investors who have “played the game” long enough know from experience to do this; it’s a simple money management tool that keeps you in the game and prevents you from losing all your capital.  More importantly, it prevents you from allowing your emotions to get the best of you.  Paraphrasing Jesse Livermore’s famous maxim, “A trading position that goes against you from the start is likely to be a losing proposition, so you should get out immediately.”

Along these lines, W.D. Gann taught that a stock or commodity that repeatedly stops you out with a loss should be avoided altogether since there could be a psychological reason for the constant losses.  Gann believed it’s better to stick to trading vehicles in which you’ve shown you can profit from. 

Gribbohm’s explanation for his stubborn refusal to cut his losses was revealing: “You just get caught up in the whole, ‘I’ve got to win my money back [thing].” 

The above statement perfectly summarizes a truism of investor psychology which has led to countless losses for the average market participant.  The way to overcome this all-too-human failure is to steel yourself beforehand with the mindset of cutting your  losses the minute the trading position goes against you by a certain percentage.  The use of a judiciously placed conservative stop-loss is paramount, and stops should always be employed in every trading or investment position. 

Traders/investors should also consider such factors as relative volatility before initiating a new position, especially with the advent of High Frequency Trading (HFT), which if prevalent in a particular asset can increase your chances of being stopped out with a loss.  This is one of the biggest tip-offs of a manipulated market.  If the asset you’re watching is trading erratically or tracing out a pattern which can’t be easily classified by conventional chart pattern theory, it’s best to avoid it.  Instead, trade only in assets which display “clean” and tight looking consolidation and/or continuation patterns.  Better safe than sorry.

Always compare the recent and historical trading pattern of the asset you’re interested in to a broad market benchmark such as the S&P 500 or the CRB Index (depending on whether it’s a stock or commodity).   It’s also imperative that the stock or commodity you choose to trade should have ample liquidity on a daily basis which makes it easier to enter or exit the trade.  Lightly traded stocks and commodities are the ones most liable to manipulation by vested interests. 

Manipulation is an unfortunate fact of the financial market.  Stocks and commodities have always been subject to manipulation, whether by individuals, pools, central banks or even governments.  If you are unable to come to terms with this reality then it’s best to avoid participating in the market altogether.  But if you’re able to come to grips with this then there is money to be made once you’re able to spot the tell-tale signs of manipulation, a skill which becomes better with experience.  

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