Pump and dump refers to an illegal practice in trading that attempts to boost the price of stocks. The scheme works by providing exaggerated or misleading information to prospective buyers, in the hope of persuading a large number of people to purchase the stock. When a surge of people buy it, the price goes up, and the perpetrators of the scam then sell their own stock at highly inflated prices.
Who Drives Pump And Dump Schemes?
Pump and dump schemes can be carried out by anyone who has a personal interest in a stock price rising; usually, this would be a company shareholder, or the company itself.
A company would even sometimes pay a team of promoters to falsely hype up a stock. Once enough people have been convinced of the stock’s potential, and the stock price rises, the company or shareholder will sell shares at a huge profit.
This practice is punishable by law, and those engaging in it could be subject to heavy regulatory fines.
The most famous example of a pump and dump scam was in the film The Wolf of Wall Street.
This movie was based on a true story of how a man becomes rich by cold calling unsuspecting amateur buyers and grossly exaggerating the profitability of small-company stocks.
His enterprise grew into a large team of people that traded in penny stocks, which were part of small companies that were otherwise of little buying interest.
He managed to sell millions of shares in tiny, non-descript companies, falsely inflating their value, and then selling his own shares before the stock reached a ceiling and crashed.
The Wolf of Wall Street – otherwise known as Jordan Belfort – grew from rags to riches in the 1980s using the pump and dump scam.
The practice rose in popularity following this. However, although it is illegal and much more broadly recognised, it still remains today as many people try to copy the questionable success achieved by Belfort.
Pump and dump scams were typically carried out via cold calling, as they originated before the internet was widely used.
However, the internet has given pump and dump traders even more opportunity to reach buyers. Scammers regularly post ads and messages online in targeted places, claiming to have inside information about a company that will lead to an increase in its share price.
You can spot pump and dump adverts almost anywhere – including within your social media feeds, as pop-ups on sites you visit and even in your email inbox.
How To Recognise A Pump And Dump
When you’re starting out in the world of trading, it can be difficult to know when a stock is being pumped. Many people start out trading smaller “penny stocks” due to their accessibility, lower risk and growth potential.
However, these are the stocks that are most often targeted by pump and dump traders – and these unscrupulous individuals mainly rely on the inexperience of beginner traders to follow through on their schemes.
It is possible to trade pump and dump stocks.
However, to be able to identify a pump and dump, you must first recognize the signs of the stock being artificially inflated.
The most obvious sign is the promise of huge profits. If someone is telling you that a stock is about to explode and you’ll make a fortune, be cautious. It’s difficult to predict when profits will materialize, so anyone guaranteeing them is likely up to something.
Pump and dump schemes tend to focus on penny stocks, which are low-value and often unknown companies. While not all penny stocks are pump and dump targets, many are. To avoid falling victim to these scams, it’s important to do your research before making any investment decisions.
Spotting a Reverse Takeover
Private companies looking to go public often use a reverse takeover to achieve this goal. To become a publicly traded company, a certain number of shares need to be sold.
Once you’ve reached enough shareholders, your company becomes public.
You may be being promised profits from buying a stock, when the real intention is to take a not-so-profitable company public. Again, do your research and, if the company doesn’t look like a good buy in your eyes, don’t buy it.
Look At The Trends
Before you buy a penny stock, check out its graphing trends. If you can see by the graph that a stock’s performance has remained steady for a long period of time, yet is now experiencing a sudden spike, it’s likely to be a pump and dump.
This is particularly likely to be a pump and dump if there is no apparent reason for the spike, i.e. no happenings in the market that could have contributed to an organic rise in price.
Stock prices do not start going up for no reason – they will either react to market conditions or they will have been the target of a pump and dump scam.
Surge In Trading
You can also identify a pump and dump if you notice a sudden spike in the number of shares being purchased. If that number has been relatively low and is suddenly up in the millions, that’s extremely suspect, and you should avoid it like the plague.
It can be difficult to know when you’re being mis-sold information about a stock, and are therefore the target of a pump and dump scam. Many people, as a result, could miss out on genuine stock buying opportunities due to over-exerting caution in this field.
There are ways to avoid being a victim of pump and dumps.