Warrior Trading Blog

5 Tips For Avoiding A Pump And Dump Stock

Pump And Dump

Jordan Belfort, of the blockbuster hit The Wolf of Wall Street, swindled investors out of millions of dollars in the early ‘90s using the “pump and dump” stock selling fraud scheme at his brokerage firm, Stratton Oakmont.

The scheme later caught up with him and he was imprisoned for 22 months between 2004 and 2006. He was also forced to pay back $110 million to the investors he had deceived. This was part of an agreement under which he testified against numerous subordinates and partners involved in his stock manipulation strategy.

Belfort definitely goes down as one of the biggest Wall Street crooks in history, but some people are still pumping and dumping stocks to illicitly earn millions of profits.

What is a pump and dump scheme?

Pump and dump is a form of securities fraud where an individual investor, investment firm, or a company relentlessly promotes a stock they bought at a low price, often based on misleading, false, or grossly exaggerated statements and information, in order to boost the price of that stock.

The fraudsters will pump up the price of the stock and convince other investors to buy it by promoting it through social media channels, e-mails, newsletters or posting to online chat rooms and message boards.

They will then offload their shares to the new investors who enter the market at a higher price, leaving them holding typically a worthless security.

Why they occur

Fraudulent investors manipulate a stock’s price in order to drive it higher with the hope of making a quick profit at the expense of other investors.

The stock is generally promoted “the next big thing” or a “hot tip” by stating that upcoming announcements will push its price through the roof. They often back this up with ‘technical analysis’ or ‘insider information.’

This creates demand, which raises the price of the stock dramatically (especially on stocks with low floats).

Pump and dump stock example

For example, let us say that ABC Inc is a new company with a market capitalization of $20 million and its shares are trading at $0.05 apiece. Pump and dump fraudsters would purchase a large amount of shares and would then would start promoting the stock via social outlets and message boards.

Since these stocks are typically cheap and have low floats, prices can increase dramatically when demand picks up.

When the stock’s price increases significantly as unsuspecting investors buy up the shares, the pump and dump schemers start unloading they shares at higher prices.

For example, say the penny stock rises to $0.12 a share in the coming days and weeks, valuing ABC at $48 million. Organizers of the scheme then sell their shares netting a quick and easy 140% return. Eventually, the stock tumbles to pre-pump levels and leaves duped investors with huge losses.

So, what can investors do to avoid being victims of pump and dump artists?

Tips on how to avoid pump and dumps

  • Be wary when unknown sources flood you with information

Avoid relying on every press release, email, and other promotional materials like blogs and newsletters that are sent to you by unknown sources.

Some of them are often sent by paid promoters or insiders to convince people that a stock has a huge upside potential.

Be cautious if your e-mail address is flooded with communications over a short period of time, particularly if the information only focuses on the positives of a stock with no mention of risks.

  • Check the age of a company before buying its stock

Before investing in a penny stock, make sure to know how long the company has been in business. Pump and dump fraudsters will often try to convince people that a young company will become profitable within a short period of time.

More importantly, you need to know whether the company has met all registration requirements.

  • Be skeptical of reverse mergers

Proceed with caution when considering whether to put your money in reverse merger companies. A reverse merger is a way for a private-held company to go public by merging with an existing public company.

That means the private company doesn’t have to file some crucial documents with the SEC. As such, investors planning to buy its shares will not have a chance to know its risks, liabilities, financial assets, and other legal details.

Reverse mergers often create a perfect opportunity for penny stock pump and dump scams.

  • Find out if the stock is listed on an unregulated market

Balance sheets, income statements, and cash flow statements guarantee nothing.

There are still many examples of pump and dump schemes involving companies that file reports with the U.S. Securities and Exchange Commission (SEC), especially on the over-the-counter (OTC) Bulletin Board.

Unlike the New York Stock Exchange or the Nasdaq, the OTCBB is not part of the well-regulated stock market. As much as possible, avoid buying stocks that are listed on unregulated exchanges as they carry greater risks.

  • Know who is in charge of the company

Before buying a stock, check for relevant information regarding the people behind the company. Do you feel that those running the company are incompetent? How well is the business managed?

Is the business innovative? Is the management involved in scandals? What is its general culture? There are some of the questions you should ask yourself to avoid people dumping their stocks on you.

Final Thoughts

Pump and dump scams cost American investors between $3 billion to $10 billion annually, according to James Cox, a professor of securities law at Duke University. In recent years, this illegal practice has become a common thing thanks to the power of the internet, particularly open sources of information and social media sites.

Investment advice such as stock tips may be convenient, but it is important to remember that are still plenty of wolves on waiting to pounce on you. So, always perform your own research on recommended stocks in order to avoid pump-and-dump schemes and other get-rich-quick scams.

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