What Is Circular Trading?
Circular trading is a fraudulent scheme where sell orders are entered by a broker who knows that offsetting buy orders for the exact same number of shares at the same time and, at the same price, have either been or will be entered.
How Circular Trading Works
Such a trading scheme does not represent a real change in the beneficial ownership of the security. Circular trading artificially inflates volumes as a way to show that a security has liquidity, maintain share price at the desired level, and to act as proof that there is market interest in the stock. The practice is banned and illegal in numerous countries.
How Circular Trading Manipulates the Market
If circular trades persist, they can create a false sense of activity around a stock that may influence its price. For example, if the trading price of a security was on a trajectory to fall below levels desired by certain shareholders, a circular trade could serve to buttress the share price by giving the impression that new owners are buying the stock at the desired level. This activity might convince others, who are not privy to the scheme, to buy into the stock as they assume the trades indicate there is a growing interest in the stock. There may even be some presumption that the company is about to release news that, once made publicly known, would drive up the price.
However, since the circular trade scheme does not introduce any real change in ownership nor represent any actual action about to be announced, there is no basis for that perception. If the shares do rise in price as a result, the value is fraudulently inflated. Once the scheme is discovered, that artificial escalation of the stock price will collapse in on itself, taking with it the funds invested by others.
Some initial public offerings (IPOs) and penny stocks may be especially susceptible to circular trade schemes, particularly if certain shareholders want to create the appearance of intense trading activity and buzz surrounding a stock. The intention is to encourage the stock to be pumped up, driven by the attention the cycle of trades attracts. A circular trading scheme typically requires several participants to create the illusion of shares being acquired by new owners when, in fact, the same shares are simply passed through with no actual change in value.
Day traders might fall victim to such a scheme if they are looking for new investment opportunities, see volume activity on a stock, and buy into it expecting the shares to escalate in value.