All you need to know about pump-and-dump scheme in the stock market
Pump-and-dump schemes involve an individual or group of investors advertising a stock they own to drive up its price, so they can benefit from the price rise by dumping the shares. In this article, we’ll examine pump and dump schemes in further detail and discuss how to spot them.
What is a pump-and-dump scheme?
Pump and dump schemes artificially inflate the value of a stock by encouraging others to buy it. Such people spread misinformation about the said stocks on social media, and create excitement around that stock. As people start buying these shares, the stock price rises, and that’s when these people sell their shares and pocket the profits.
How is a pump-and-dump done?
Historically, cold calling was used for pump and dump operations. Now that the internet is widely and readily available, it is easier to do so. This plan consists of two elements:
Fraudsters "pump" a stock by spreading fake news that they have insider information and should buy immediately.
To "dump" or sell off at a high price once prices have risen. If the prices drop sharply after the traders sell their shares, new investors will lose their investment.
Since small-cap stocks are the easiest to manipulate, they are the primary target of pump-and-dump schemes. For such stocks, a small number of new purchasers are needed to increase the stock price. Due to the influx of new investors, stock prices rise sharply. Then traders sell their stock for a quick profit. Although each pump and dump plan may have unique characteristics, they all work by manipulating the supply and demand for a stock.
How to identify pump and dump schemes?
The pump and dump stocks can be recognised using the 4-step approach.
Step 1: Treat all unsolicited investment offers with extreme suspicion
These days, investors can be pitched with a simple comment, tweet, email, or even WhatsApp messaging. Usually, you wouldn’t know sender of the message. But even if you do know the source, chances are, they may be reacting to a message they got. So don’t take your stock advice from just anyone and be conspicuous about your trades.
Step 2: Keep an eye out for warning signs
Warning signs include, but are not limited to:
Extremely high investment return guarantees.
Conditions when pressure is being applied to seize a brief window of opportunity
Claims that the advice is based on private or proprietary information.
Step 3: Keep an Eye Out for Advertisements
The influence of many YouTubers, Twitter users, Instagram celebrities, etc., extends beyond these platforms. For your own protection as an investor, pay close attention to the disclaimers made by these content creators whenever they discuss or advocate a specific stock.
In these resources, three types of disclaimers can be found:
No Disclosure: For this reason, you should treat the content as fraudulent and disregard the originator.
Vague Disclosure: In this scenario, the creator must clarify whether or not they have been compensated for their content.
Buried Disclosures: They are obscured by small, difficult-to-read types. They would disclose that they might get paid by the businesses they write about.
These acceptable print clauses are standard practice for every business. Due to the financial stakes involved, you should read every piece of advice on these sites with the utmost scrutiny.
Step 4: Consider the risks and do your homework before making any investments
You, as an investor, need to do your homework before putting your money down. Mutual funds and other intelligent investing services are great options if you need more time or expertise to conduct your research.
Numerous examples exist of "average" investors employing "average" abilities to purchase "average" risk instruments.
What are the types of pump and dump schemes?
Possible variations on the pump and dump utilised by con artists include:
• Classic pump and dump scheme: This plan aims to artificially inflate a specific firm's stock price by means of telephone calls, bogus news releases, and the dissemination of "inside" information.
• Boiler room: Several brokers work for a small brokerage firm and use dishonest sales tactics to bring in customers. The brokers use cold calling to sell stocks. They're selling as many shares as possible to drive up the price. When the value of the stock goes up, the brokerage business cashes out its holdings and makes a tidy profit.
• "Wrong number" scheme: There is a chance that you will receive wrong number calls. To cover their tracks, scammers may pretend that you accidentally received a call. It's a calculated move made to raise interest in and demand for a specific stock among investors.
Examples of pump and dump schemes
Both Luke and Lucas have invested in the stock market. For a total of $5,000, Lucas invests in a purchase of 1,000 shares of a corporation at $5 each. He then begins spreading false information that, thanks to the company's stellar success, will soon be taken over by the government.
He says there will soon be a three-day spike in the stock price and its price will reach $30. Luke hears this and notices that the stock price is increasing. He invests $300,000 by purchasing 1,000 shares of the company at $30 per share.
The share price is expected to reach $50 shortly. Ultimately, he decides to cash out all of his shares, at which point he will have made $45,000. There was no real growth to speak of, and now that the rumours have died down, the stock price has dropped below $5. While Lucas is awash in cash, Luke is sinking deeper into debt.
A free meal does not exist. As an investor, keeping this in mind will help you stay clear of pump and dump scam and similar schemes.
Q. Is it against the law to engage in pump and dump?
Since pumps and dumps cause innocent people to lose a lot of money, they are prohibited by several laws. Regulatory agencies closely monitor price manipulation, which issues fines to those responsible.
Q. What are the issues with pumps and dumps that make them so undesirable?
Stock price manipulation schemes entail spreading misleading information to increase stock prices artificially. There is no real growth behind the price increase, and once the manipulation stops, the price falls, leaving many investors with nothing.
Q. How do you identify a pump-and-dump scheme?
If there is an unusually high volume of calls, emails, or social media posts about a stock, with the promise of huge returns, you can be sure it's a pump and dump.
Trading in a company's securities while possessing non-public, potentially market-moving information is known as insider trading.
When the value of the securities held in a brokerage account goes below the maintenance margin, the account holder receives a margin call.