A pump and dump is an investment scheme where untrue statements are made public about a particular stock with the purpose of artificially increasing the stock price. The scheme is essentially a scam and the perpetrators use this opportunity to sell their positions that they acquired before the fake news came out at much higher prices than they bought.
A pump and dump is basically broken down into two parts. The first part is where the perpetrators boost the price of a specific stock using misleading statements. These statements are released via social media platforms or bulletin boards.
The second part takes effect once the stock price has increased. As more people find out about the news and are duped into buying the stock, prices rise and the ones pumping it are now selling their shares to the unsuspected traders buying it at the inflated prices.
According to the SEC, pump and dump scams also occur on the Internet since it provides a platform for scammers to post messages and for readers to have access to these messages.
The insiders will claim to have “inside information about an upcoming development in a certain company” resulting in the increase of the stock price. In reality, the promoters are either paid or they are company insiders who stand to gain from the price increase.
How A Pump And Dump Works
The promoters or company insiders begin the scam by promoting a particular stock as the next big thing. They are able to do so via a news announcement which is designed to boost the stock’s price. What you need to know is that details for each scam are usually different. Despite this, the principle is the same – taking advantage of supply and demand forces.
According to financial experts, the scam works on small and micro-cap stocks since they have smaller market caps. These are usually traded over the counter. The small and micro-cap stock companies are usually highly illiquid and thus sharp price movements occur when volume increases.
When the price has been boosted, the scammers will proceed to sell their holdings thus making a larger short term gain.
If you have watched both Boiler Room and The Wolf of Wall Street movies, then you have an idea of what pump and dump scams are. In the movies, a warehouse full of telemarketing stockbrokers selling penny stocks is featured prominently. The brokerage firms were market makers and thus they held large volumes of stock that had questionable prospects.
Leaders in the firms provide their brokers with high commissions and bonuses for having placed penny stocks in several clients’ accounts. As a result, the brokers pumped up the stock prices via high volume selling.
When the selling volume attained critical mass, the firms dumped their shares raking in huge profits. This resulted in the stock price dropping below the original selling price which led to big losses for customers.
Thanks to improved technology, pump and dump scams can now be run by anyone with access to an online trading account. Furthermore, the scammers need to convince investors to purchase a stock that is allegedly “hot.”
The scammers can convince others by purchasing more units of a stock that is trading at a low volume thus boosting the stock’s price. These actions will convince others to buy the stock. When the schemers feel the “buying pressure” is close to fall off, they will dump the shares thus making profits.
Pump and dump schemes are illegal and are punishable by law. Furthermore, the schemers will be required to pay heavy SEC fines. The good news is that as an investor, you can protect yourself against these schemes. Before buying into any” hot stock”, do your own research. This will eliminate the chances of you being duped.