September 2, 2011 | In: General
What Is Wash Trading?
I have written this article on one of my other financial websites. Since I have now decided to deprecate the other website, I thought the article can be of good use here.
Wash trading is an illegal practice where an investor buys and sells the same stocks simultaneously in order to inflate the stock price. According to the SEC, “a wash trade is a securities transaction which involves no change in the beneficial ownership of the security.”
How It Works
Wash trading is about creating hype. The most common (and obvious) technique of wash trading is selling stocks from a company through a brokerage firm, and buying the same stocks of the same company through another brokerage firm. This will inflate the volume and will draw the attention of other investors, who will look into buying the stock, thinking the high movements are real. This usually drives the price of the stock up.
An Example of Wash Trading
BIOS is a stock with typically a low volume. An investor buys 10,000 shares of BIOS, he then sells them in a few minutes, and then buys them, and then sells them (every 5 minutes). We know that the trading day starts at 9:30 and ends at 4:00, so he can do this buy-sell strategy 66 times, which means that investor alone will inflate the volume by 660,000 shares, making the daily volume 3 times of what the average is (average volume on BIOS is around 330,000 shares/day). At one point, other investors will start noticing the extraordinary volume on the stock, and will start getting into the game (e.g. buying the stock), thinking that someone knows something they don’t. When the real activity start happening, the stock price will go up in a natural way, and this is how the investor that started the wash trading process makes money.
Why Is Wash Trading Illegal?
Wash trading is illegal because it’s misleading and artificially inflates the price of the stock when there is no concrete reason for the stock price to go up. Wash trading, when discovered, can easily corrupt the image of the involved company (from an investor’s point of view), even if the company is not involved in the wash trade activity. Additionally, whoever initiated the wash trade usually has the intention to sell all the stock back, at a higher inflated price, leaving other investors who were duped into buying the stock, with an inflated stock worth less than what they paid for.
When Was Wash Trading Declared To Be Illegal?
Wash trading was declared to be illegal in 1997, after the Farni wash trading activities with the Angeion stock was uncovered, which moved the stock price to a high of $10.375 in March of 1991. The stock then fell to a low of $2.75 in July of 1991.
This article (as well as all other articles on this website) is an intellectual property and copyright of Fadi El-Eter and can only appear on fadi.el-eter.com.