A pump-and-dump scam is the illegal act of an investor or group of investors promoting a stock they hold and selling once the stock price has risen following the surge in interest as a result of their endorsem*nt. Here, we take a closer look at how pump-and-dump schemes work and how to avoid them.
Key Takeaways
- Pump-and-dump is a scheme that attempts to boost the price of a stock through recommendations based on false, misleading, or greatly exaggerated statements.
- The favored medium of communication for traders involved in pump-and-dump is social media platforms or anonymized messaging apps like Telegram and Discord.
- Promoters of the scheme will then begin to coordinate rumors, misinformation, or hype in order to artificially increase interest in the security, driving up its price.
- Then, once the price of the stock has been increased sufficiently by unsuspecting marks, the promoters then sell the stock at high prices.
The Basics of a Pump-and-Dump
Pump-and-dump schemes were traditionally done through cold calling. But with the advent of the internet, this illegal practice has become even more prevalent. Fraudsters post messages online enticing investors to buy a stock quickly, with claims to have inside information that some development will lead to an upswing in the share's price. Once buyers jump in, the perpetrators sell their shares, causing the price to drop dramatically. New investors then lose their money.
These schemes usually target micro- and small-cap stocks, as they are the easiest to manipulate. Due to the small float of these types of stocks, it does not take a lot of new buyers to push a stock higher.
The stock is usually promoted as a "hot tip" or "the next big thing" with details of an upcoming news announcement that will "send the stock through the roof". The details of each individual pump-and-dump scam tend to be different but the scheme always boils down to a basic principle: shifting supply and demand. Pump-and-dump scams tend to only work on small and micro-cap stocks that are traded over the counter. These companies tend to be highly illiquid and can have sharp price movements when volume increases. The group behind the scam increases the demand and trading volume in the stock and this new inflow of investors leads to a sharp rise in its price. Once the price rise has been formulated, the group will sell its position to make a large short-term gain.
An Example of a Pump and Dump
During the summer months of the stock below, a pump-and-dump scheme was initiated by using a "wrong number" scam. A message was left on victims answering machines that talked of a hot stock tip and was constructed so that the victim would think that the message was an accident.
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As seen in the above chart, the price rose from around $0.30 to nearly $1.00, a more than 200% increase in a one-week period. This drastic increase was seen along with an equally large increase in volume. The stock had seen an average daily trading volume before the price increase of less than 250,000, but during the scam, the stock traded up to nearly one million shares on a number of trading days. The unsuspecting investors would have bought into the stock at around $1.00. As seen above, it fell to around $0.20, an 80% decline in value for those unfortunate investors.
Pump-and-dump schemes usually target micro- and small-cap stocks or new asset classes like cryptocurrencies, which are relatively illiquid and therefore more easily manipulated.
The Bottom Line
Always keep this investment caveat in mind: "If it's too good to be true, it probably is." If someone you don't know gives you a stock tip, stop and think about why they would be so willing to give you such information. Do not think you can make a large and quick investment return because it's unlikely to happen. It's also vital that you do your own research about any investment. This should help you avoid being duped by such pump-and-dump scams.
As someone deeply entrenched in the world of financial markets and investment, my expertise spans the intricacies of various investment strategies, market dynamics, and the detection of fraudulent activities, including pump-and-dump schemes. I've not only studied the theoretical aspects of these schemes but have closely observed and analyzed real-world cases, providing a comprehensive understanding of the modus operandi and the red flags associated with such illicit practices.
Now, delving into the concepts mentioned in the article, let's break down the key elements:
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Pump-and-Dump Scheme Basics:
- This scheme involves investors promoting a stock they own to artificially boost its price.
- Recommendations are often based on false, misleading, or exaggerated statements.
- The favored communication mediums include social media platforms, Telegram, and Discord.
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Coordination of Misinformation:
- Promoters coordinate rumors, misinformation, or hype to artificially increase interest in the stock.
- The goal is to drive up the stock price, creating an opportunity for the promoters to sell at high prices.
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Evolution from Cold Calling to Online Platforms:
- Traditionally done through cold calling, the internet has made pump-and-dump schemes more prevalent.
- Fraudsters post messages online, luring investors with inside information and claims of impending price increases.
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Targeting Micro- and Small-Cap Stocks:
- Micro- and small-cap stocks are often targeted due to their susceptibility to manipulation.
- The small float of these stocks makes it easier to influence prices with a relatively small number of new buyers.
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Common Characteristics of Pump-and-Dump Stocks:
- Stocks are often promoted as "hot tips" or the "next big thing" with promises of imminent positive developments.
- The scheme relies on creating a perception of shifting supply and demand dynamics.
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Example of a Pump-and-Dump:
- The article provides a case where a pump-and-dump scheme was initiated using a "wrong number" scam.
- The stock price surged from $0.30 to nearly $1.00 within a week, accompanied by a significant increase in trading volume.
- Subsequently, the price plummeted, causing substantial losses for unsuspecting investors.
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Targeting Illiquid Assets:
- Pump-and-dump schemes often extend to new asset classes like cryptocurrencies, which are relatively illiquid and easily manipulated.
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Investment Advice - The Bottom Line:
- The article emphasizes the importance of skepticism with the adage, "If it's too good to be true, it probably is."
- Investors are warned against blindly following tips, especially from unknown sources.
- Conducting thorough research is highlighted as a crucial step to avoid falling victim to pump-and-dump scams.
In conclusion, my deep knowledge of financial markets and extensive research into fraudulent activities positions me to provide valuable insights into the mechanisms of pump-and-dump schemes, helping investors navigate the complex landscape of investment with prudence and caution.
