Markup 101: How Obscure Stocks Are Manipulated - TheStreet

Markup 101: How Obscure Stocks Are Manipulated

Generous bids in a thin market create momentum. Just don't wait too long to sell.
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Can hedge funds rig the stock market?

The headlines over Durus Capital's "inadvertent" cornering of shares in two medical firms,

Aksys

(AKSY)

and

Esperion

(ESPR) - Get Report

, have investors wondering exactly that. But while "marking up," the process by which powerful investors move shares higher by timing big purchases in certain stocks, is an illegal form of market manipulation, experts say it's far from uncommon.

"If you hold a block of a stock with a low float or low volume, you can control the flow of stock out there as if you owned

a large percentage of the shares outstanding," said Charles Ryan, equities analyst at BB&T Asset Management. "You can see this happen if you buy too big of a position. It becomes illiquid and is hard to sell. It can work against you if you're trying to get out fast, but it can work for you if you're holding it and buying more."

This happens at the end of every quarter, when fund managers looking to boost performance buy shares en masse, bidding up their prices in what is commonly called "window dressing." And while that's a marketwide phenomenon, anyone with deep pockets looking to move shares in a single company can take a run at one of thousands of low-cap, small-float stocks that are easily influenced.

One reason marking up works is that short interest fuels the fire. By outspending the short-sellers, a big investor can force the shorts to cover their bets that the stock will fall by buying stock at higher and higher prices. Some well-timed and generous bids can spark momentum to the upside, piquing the interest of other traders and enabling the process to take on a life of its own.

"Pretty much what happens is that traders see it happening and probably accelerate what is happening. If it looks to me like someone is trying to run a stock up, I'm going to jump in and try to catch a ride myself," said

RealMoney.com

contributor James DePorre. "That sort of dynamic at work accelerates what is happening."

In this way, someone looking to mark up shares need not control a huge percentage of the float to move a stock. Because shares trade only a small percentage of their float each day, a buyer would need only to control a big chunk of daily

volume

-- not the float -- and make large buys at higher prices.

The artificial demand is enough to boost shares when supply -- the amount of shares trading each day -- is constrained.

"You can easily mark up with just a small percentage of shares. Most stocks only trade a small percentage of their float in a day. And one buyer of several hundred thousand shares in a thin stock can make a big difference," said DePorre. "It isn't just their buying alone that makes the difference; it's the other traders that come in too that help."

It's a good example of Wall Street's "greater fool theory," which maintains that as long as there's another sucker out there willing to buy shares at higher prices, shares will go up. Often times, as Ryan points out, investors will think that smart money is heading into a stock when they see volume, or that there's news out that's secretly moving shares.

Given the nature of the two companies that Durus Capital was accumulating -- both small names in the momentum-heavy medical equipment space -- it's not hard to see why investors might have suspected behind-the-scenes action. Ryan said this can be a problem, "especially in biotech. All it takes is one bit of hot news and something can double. Sometimes there's a thought that something is out there that you just don't know."

Ultimately, marking up shares in a company is illegal. But it's nearly impossible to prove, because the

Securities and Exchange Commission

would have to prove that someone knowingly and maliciously bid shares up.

"There are general prohibitions about any artificial price manipulation, but it isn't always a black-and-white issue," said DePorre. "Who is to say that a buy is for the purposes of manipulation vs. just a normal buy in the course of business? It's very tough to prove what the real motivation is for buying and selling a stock."

The practice is also far from risk-free even outside the realm of regulation. By buying too many shares, a trader risks exhausting the market and running out of buyers, potentially causing losses if one is forced to sell. It's all in the timing: Wait too long to sell, and suddenly you're the fool.

While hedge funds almost certainly can't rig the broader market on a large scale, the truth is they certainly try to do it in smaller stocks from time to time.

"You have to watch that sort of thing at the end of the quarter, but other than that, it is extremely hard to detect," DePorre said. "Funds don't do it to

a great extent, because they get trapped."