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Saturday, April 21, 2012

Was it a freak ‘error’ trade or a ‘short and distort’ scam?

For those who don’t have much experience in the stock market, the trading anomaly observed last Friday (Apr 20 ‘12) may have come as an unpleasant surprise - specially for those who prefer to trade in the F&O segment. Here are the facts, as already published in news media:

  1. The Nifty (and the Sensex) were drifting along sideways in a very narrow range for the better part of 5 hours, when suddenly the bottom seemed to fall out.
  2. Apparently Nifty’s future contract for April saw a freak trade that valued the contract 300 points lower than the Nifty spot price. Earlier, Infosys stock futures dropped more than 400 points in another freak trade.
  3. The two freak futures trades taken together caused spot Nifty (and the Sensex) to plummet.

Several traders tried to explain away the anomaly by calling them trading ‘errors’. But the NSE authorities denied that there were any ‘errors’ and said that the existing systems have enough checks and balances. If there had been only one freak trade, it could have been attributed to an ‘error’. But two freak trades in the same day were too many.

So, what really happened? The answer will get revealed after the SEBI and/or the NSE authorities investigate the freak trades. But circumstantial evidence may be pointing to a well-planned ‘short and distort’ scam. This is a less known scam than the ‘pump and dump’, but the underlying logic is the same - to separate inexperienced investors from their hard-earned money.

How does the scam work? Scamsters first open short positions in an index/stock, and then spread unsubstantiated rumours or distorted facts through email, SMS messages and message board postings in investment groups. In this case, a message doing the rounds earlier in the week predicted that the market will crash on Apr 20. No reasons were given. Some hints about a negative astrological configuration were dropped. When the actual crash came, the short positions were quickly covered. The Nifty bounced up smartly, and closed higher on a weekly basis.

Some times, the scam is also used to get out of tight situations. If some operators had shorted Nifty prior to RBI’s policy announcement and had been caught unawares by the surprising 50 bps rate cut and the subsequent rally, how would they cover their losses? By pushing down the index level below their shorting level – by hook or by crook.

Those who panicked and sold off learned a painful lesson: Do not pay attention to unsubstantiated predictions about the market – even if such predictions turn out to be correct at a later date.

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