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.

Stock Chart Pattern – Delta Magnets

There is one – and only one – reason for discussing the stock chart pattern of Delta Magnets. It is to warn small investors to stay away from buying small-cap companies with unknown products or services and horrendous fundamentals that start shooting up like Diwali rockets only to explode with a loud bang.

Such companies suddenly become ‘hot stocks’ near bull market tops, burn a big hole in the pockets of small investors and disappear without a trace. Some times, they reappear again in a new ‘avatar’ – just like Delta Magnets has done – to go through the entire cycle of shooting up out of nowhere and burning bigger holes in investor pockets.

May be this time it is different? I don’t think so. Let us go back in history. A company called G. P. Electronics started manufacturing hard ferrite (ceramic compound) magnets with Japanese collaboration at its factory in Nashik back in 1985. These magnets – of various shapes and sizes, viz. arc, ring, rectangular – find applications in motors and dynamos used in bicycles, two, three and four wheelers, as well as in loudspeakers, telephones, headphones.

After 25 years of operations, the company’s sales were Rs 9.32 Crores in 2009-10, on which it made an ‘adjusted’ net profit of Rs 13 lakhs. On a TTM EPS of 1.46, the P/E ratio is 47.6 at today’s closing price of 69.55. No one knew or cared much about the company. For the past 9 years the stock has oscillated between Rs 5 and Rs 25 – except for peaks of 42 in 2005 and 43 in 2008. That same year, the name of the company was changed to Delta Magnets. That didn’t prevent the stock from making a low of Rs 9 in Dec ‘08.

Then, from a level of Rs 21 in Jul ‘10, the stock shot up to touch Rs 70 in 4 months. What happened? The market became aware that Delta Magnets is owned by Delta Corp – another ‘hot stock’ with poor fundamentals that supposedly has expertise in real estate and casinos. But wait a minute! Isn’t Delta Corp the new name of an unknown textile company called Arrow Webtex?!

To summarise, an unknown textile company changed its name to become an overnight expert in casinos, and then acquired a hard ferrite manufacturer that has been showing losses at the operating level for the past five years (may be even more?), and changed its name as well! Reminds me of a school mate who used to bring up the rear in class. He changed his name through an affidavit in court just before going through an arranged marriage. Wonder why?!

If you are one of those who think that it is all about taking risks and making quick short-term gains, have a look at the one year chart pattern of Delta Magnets before you throw all your money away:

Since Jul ‘10, the stock has been moving up by hitting frequent upper circuits and all three EMAs are moving up with the stock well above them. Typical sign of a bull market, right? Yes and no. While it looks like a very bullish chart, look at the peak volume days on Jul 16 ‘10, Aug 27 ‘10 and Nov 1 ‘10. All three were down days that occurred after the stock hit a new high. A clear sign of ‘pump and dump’ distribution.

The RSI and slow stochastic are in their overbought zones. The MACD is above the signal line and both are moving up sharply. The ROC (and RSI) failed to make new highs, and are showing negative divergences with the stock’s price. The stock is getting primed for another ‘dump’ operation.

Looks like retail interest is pushing the stock higher – thanks to a number of ‘buy’ calls by self-styled stock ‘gurus’ who copy-paste each others’ recommendations in different fora. The stock may move up some more – thanks to the hype created by frequent announcements of acquisitions in India and abroad. Wonder where the money for the acquisitions is coming from!

Bottomline? The stock chart pattern of Delta Magnets is a classic example of how small investors get duped by pump-and-dump schemes. If you enter now, be sure you understand the consequences of  the ‘greater fool theory’. Smart investors can read this post for entertainment (hope I’ve provided enough!) and avoid the stock like the plague.

How to spot and avoid 'pump and dump' stock scams

Before I explain what a 'pump and dump' stock scam is and how you should avoid it, a brief digression may be in order. Such scams tend to proliferate during a particular environment and state of the stock market. And we are bang in the middle of exactly such an environment.

The Indian stock market has been on a one-way ride upwards ever since the global markets changed trend from bear to bull back in March '09. Stocks in practically all sectors have moved up by leaps and bounds.

The election results in May '09 provided a major boost to the bulls. But after gaining more than 100% from the Mar '09 low of 8000 to the Oct '09 high of 17500, the Sensex has hardly progressed much in the past 6 months. At today's close of 17822, the Sensex has gained a mere 1.8% over its Oct '09 high.

Most of the index stocks and the good non-index stocks have outperformed the index and are trading at prices that are considered 'too expensive' by small investors. Many new investors have heard stories about the phenomenal gains that can be made in stocks and are itching to jump in - or have already done so.

The stage has been set for scamsters to exhibit their bag of tricks. The first stage of the scam is well hidden from the unwary public. Promoters and associates of small, unknown companies trading at low prices join hands with a group of friendly brokers and start buying up their own shares.

Since the floating stock of such companies tend to be small, a few 'buy' orders help to 'pump up' the stock's price, which starts hitting upper circuit limits. A few judicious emails to various Internet investment groups and SMS messages to individuals reveal a huge upcoming order, or a phenomenal new technological breakthrough, or 300% growth in profits in the just-concluded quarter and a likely bonus issue.

That is enough to lure hordes of small investors to place large 'buy' orders in an effort not to miss out on a fantastic multibagger opportunity. The stock continues to hit upper circuits for a few more days. That is when the 'dumping' starts.

The promoters and their friends start unloading the stocks - in small quantities initially, which get easily absorbed in the buying frenzy. Then the big unloading happens, and suddenly the stock starts to hit lower circuits right at the beginning of the trading day. Most small investors are too inexperienced to get out, and remain stuck with large quantities of stocks that soon revert back to their earlier low-price, low-volume status.

The best way to avoid getting caught in a 'pump and dump' scam is to ignore free stock tips from unknown people. If it sounds too good to be true - it usually is. If it concerns a 'penny stock' (i.e. trading below Rs 10 for a stock with a face value of Rs 10) don't give it a second look.

Even if the stock seems interesting and is trading above its face value, don't neglect to do your due diligence. Check the debt/equity ratio and the cash flows from operations. A large debt and negative cash flows from operations are a given for these 'pump and dump' stocks.

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