Bluffers and Market Manipulation: Tricks Traders Use (Chapter 12)

If Chapter 11 was about the parasites who trade ahead of you, Chapter 12 is about the con artists who trick you into trading badly. Bluffers are profit-motivated traders who create false impressions to fool other traders. And Harris walks through their playbook in detail that is genuinely uncomfortable.

This is not ancient history. The strategies described in this chapter happen constantly. Pump-and-dump schemes on penny stocks, fake social media hype, coordinated buying to trigger momentum. The technology changes but the mechanics stay exactly the same.

Two Ways to Bluff

Bluffers use two main techniques.

Rumormongers spread information designed to move other traders in the direction the bluffer wants. The information might be outright false, or it might be true but presented in a misleading context. The goal is the same: get people to buy when you want to sell, or sell when you want to buy.

Price manipulators arrange trades at prices, volumes, and times that change people’s perceptions of value. They might execute real market trades that push prices in one direction, or they might arrange wash trades with accomplices to create artificial activity.

Both techniques work the same way. The bluffer presents information (either through words or through price action) that causes victims to draw false conclusions about what informed traders are doing. The bluffer hopes to be mistaken for a well-informed trader.

The Bubbles Never Burst Example

Harris walks through a detailed fictional example that reads like a case study from the SEC’s enforcement division. It is worth following because it shows exactly how a bluff works from start to finish.

Bill identifies a small company called Bubbles Never Burst (BNB). It is a young firm with a new technology, followed by many investors who are excited but uninformed. The stock trades at 5 dollars.

Bill quietly buys 200,000 shares over 40 trading days, using patient limit orders. His average price is 6 dollars. While accumulating his position, he starts posting optimistic messages on internet message boards under multiple fake usernames. He even has his fake personas argue with each other so it looks like a real debate.

When the company issues a routine press release about producing in China (not material news, just a status update from their latest filing), Bill immediately submits large market orders through multiple brokers simultaneously. The price spikes from 7 to 10 in twenty minutes. News services report the unusual activity. BNB appears on lists of biggest daily gainers.

Now comes the critical part. Other traders see the price jump. They query their news feeds and find the China story. They mistakenly conclude that informed traders must believe the story is extremely good news. “Why else would the market have gone up?” They convince themselves that someone knows something. They buy.

These momentum traders buy their stock from Bill. He sells 100,000 shares at an average price of 11 dollars. By day 42, even more traders have noticed and pile in. Bill sells his remaining 150,000 shares at prices ranging from 13 down to 8. Total profit: over a million dollars.

When the Bluff Fails

Harris gives the same example a second ending where it goes wrong.

This time, a value trader named Valerie knows the company intimately. She has consulted with chemists. She believes the stock is worth about 3 dollars. At 10, it is wildly overpriced. She suspects a bluffer because the China news was immaterial and the price reaction was suspicious.

Valerie starts aggressively selling short. Other value traders pile on. Bill tries to fight by buying more shares, but the value traders sell as fast as he buys. He takes on 100,000 additional shares at 10 with no price increase.

The next morning, Bill tries one last push. But overnight, the institutions that value traders tried to borrow shares from have realized what is happening and decided to sell their own holdings instead of lending them. Huge sell orders hit the open. The price gaps down to 9.5. Momentum traders disappear.

Bill has 400,000 shares and nobody to sell them to except value traders who will only buy far lower. He liquidates over 18 days at an average price of 4.5. Total loss: 1.2 million dollars.

Why Bluffing Is Hard to Prosecute

Here is the problem for regulators. Bill’s defense in both scenarios sounds perfectly reasonable: “I did careful research. I believed the stock was undervalued. I bought aggressively because I feared others would see the same opportunity. When my price target was met, I sold.”

This is indistinguishable from legitimate speculation. Prosecutors need to prove that Bill was disseminating information he knew was false or conducting wash trades. If he used fake names and public computers to post his messages (as Harris describes), tracing the posts back to him is very difficult.

Harris notes that the SEC was founded partly in response to exactly these kinds of manipulations in the nineteenth century and into the 1930s. But the problem persists. The Commission focuses enforcement on penny stocks, where these schemes are most common, but cautious bluffers who do not get greedy may operate undetected.

Bluffers vs. Value Traders

The natural enemy of the bluffer is the value trader. When bluffers push prices away from fundamental values, value traders can identify the mispricing and trade against the bluff.

But bluffers can defeat value traders if they have more capital. With enough money, a bluffer can absorb the value traders’ selling and keep pushing prices up. If value traders are not sufficiently capitalized, large adverse price movements can force them to close their positions, which actually reinforces the bluff.

This is why the most successful bluffs target securities that value traders either do not follow closely or cannot easily trade. Illiquid securities where value traders cannot take large enough positions to justify their research costs. Securities with little publicly available fundamental information. Securities that are hard to borrow for short selling (since you cannot fight a long-side bluff without going short). Small stocks where the bluffer controls a significant fraction of the float.

Because value traders can generally buy more easily than they can short sell, Harris notes that long-side bluffs are probably more common than sell-side bluffs.

The Nathan Rothschild Story

Harris includes the famous (and probably mythical) story of Nathan Rothschild and the Battle of Waterloo. Rothschild reportedly learned of Wellington’s victory before anyone else in London. But he could not just buy bonds because every trader at the Exchange was watching him for clues. So he had his agents start selling, convincing everyone that the British had lost. Prices crashed. Rothschild then bought at the bottom. When the news became public, prices soared.

Whether it actually happened or not, it perfectly illustrates the mechanics of a bluff: create a false impression of what an informed trader is doing, let others trade on that false impression, and profit from the resulting mispricing.

How Bluffers Discipline Liquidity Providers

The final section of the chapter has a technical but important insight. Liquidity providers (dealers and market makers) typically adjust their prices based on the flow of buying and selling. More buyers means prices should go up. More sellers means down.

Bluffers can exploit this if liquidity providers respond differently to large orders versus small orders. If large buys move the price more per share than small sells, a bluffer can buy in large blocks to push the price up, then sell in small lots that do not push the price down as much. The result is profit from nothing.

To avoid being exploited, liquidity providers must ensure that the price impact per unit traded is the same regardless of order size, speed, or direction. If buys and sells have symmetrical impact, bluffing becomes unprofitable because the bluffer’s own trades just generate transaction costs without creating a cumulative price change.

This principle has real implications for how market makers set their prices. Every asymmetry in how they respond to order flow is a potential profit opportunity for bluffers.

The Poker Analogy

Harris compares market bluffing to poker, and it fits well. In poker, you try to make opponents think you have better cards than you do. In markets, bluffers try to make others think they have better information than they do. Value traders are the ones who call the bluff.

But there are key differences. In poker, you have to fold if you cannot match the bet. In trading, you can hold your position as long as you can finance it. In poker, cards are revealed at the end. In trading, values are never resolved with certainty. And in trading, new players can enter at any time.

The similarity is real enough, though: the best bluffers are probably good poker players.

What This Means for You

If you are a momentum trader who buys when prices are rising and sells when they are falling, you are the primary target of bluffers. Every time you see a stock spiking on heavy volume and think “something must be happening,” pause. Ask yourself whether you actually know what is happening, or whether someone might be creating the impression that something is happening.

If you supply liquidity, make sure your pricing is symmetrical. And if you are a value trader, bluffers are your opportunity. Failed bluffs create massive mispricings that informed traders can exploit.

This post is part of a series on Trading and Exchanges: Market Microstructure for Practitioners by Larry Harris (Oxford University Press, 2003). Chapter 12 covers bluffing strategies and market manipulation.

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