Circular trading is an illegal situation where a broker makes use of his knowledge and enters sell orders knowing that those orders will be covered by purchase orders of the same size, at the same time and price.
It doesn’t seem like it would be a problem on the surface, as long as the sales and purchases were taking place between different individuals. The catch is that circular trading is often used as a way to increase interest in a questionable stock. What happens is that a group of traders get together and buy and sell the stock among themselves.
This activity shows up on the exchanges and regular investors, seeing the movement, purchase stock based upon this inaccurate information. At this point the brokers pull out, taking their profits and the unfortunate individuals who invested in the questionable stock can lose their capital.
Circular trading can profoundly affect the economy if it becomes widespread. Some individuals use it as a way to launder money acquired illegally. Tax revenue which should funnel into the government coffers is lost and investor confidence in the market decreases since they can no longer trust what appears to be a solid investment.
One case of circular trading often cited in financial circles took place in India between August and October of 2002. Brokers and clients engaged in such an investment scheme with shares of G G Automotive Gears Ltd (GGAGL). By creating artificial volumes of movement on the exchange the conspirators managed to raise the price of the stock dramatically. The group was caught and suspended from the exchange for a month.
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