What is ‘Circular Trading?’ ?
A fraudulent trading scheme which includes buy/sell of stocks by a person or many people who are acting in complicity with each other to manipulate the price of the underlying security is called circular trading.
How does it work?
As already mentioned, under circular trading buy/sell is done by the same person or a group of persons in collusion with each other to stage-manage the price of underlying security. The purchase or sale is done of the same number of shares and at the same time and for the same share worth or price so that the transaction is neutralized. The participants of the trade do their homework properly. They know the orders will be covered through reverse buying at the same price, order size and time – thus making trade successful.
Though, the trades don’t represent a net change in the amount of shares owned but price of underlying security definitely alters.
The reason behind these transactions is to change (increase or decrease) price of the underlying security by trading in different volumes.
As the trading volume increases, investor interest also gets created in the underlying security. As a result, a general investor thinks that the stock is in much demand and hence purchases the same. This leads to a chain reaction with other investors pitching in and increasing trading volume for the scrip. This also floats a rumor in the market that something major in the form of merger or acquisition is in wait.
However, in real, all this hype is created by some to fool the investors into buying a script that is not doing much.
Prevention of circular trading
SEBI has introduced price filters to prevent cases of circular trading. Now the stocks can be traded inside a given range during trading sessions and this helps in preventing intraday price swings. SEBI imposed an uniform intraday price band of 10 per cent for all securities on all stock exchanges. This is in addition to 25 per cent weekly price cap being followed by all exchanges. Also, a broker has to deposit a margin amount for every transaction. It helps in discouraging speculative and circular trading.