Pump and Dump
What is Pump and Dump?
Pump and dump is a scheme, most often used by scammers, to artificially inflate the price of a stock in order to gain profits. It is one of the oldest forms of securities fraud and remains a significant risk for investors, particularly those trading penny stocks and other thinly traded securities.
It usually involves two types of participants:
The first type is called a "pumper" — a person or group of people who attempt to manipulate the stock market by spreading false information or rumors about a company's stock in order to get other investors to buy the stock and drive up the price. This can also be done by buying large amounts of the stock to create the appearance of a buying spree.
The second type involved in pump and dump schemes are those who benefit from the rising stock price before selling it at a higher price. These participants are called "dumpers." They take advantage of the pumpers by buying the stock at a lower price and then quickly selling it at a much higher price once the pumpers have driven up the price.
How Does Pump and Dump Work?
The classic form of pump and dump works like this: the pumper (often part of a circle of co-conspirators) will pick a target stock that they believe has potential for a rapid price increase. The group will then start buying the stock in large amounts, driving up the price to attract attention from other investors and trigger a buying frenzy.
The target is typically a stock with low market capitalization and low trading volume, which makes it easier to manipulate the price with relatively small purchases. Penny stocks are the most common targets because even modest buying pressure can cause dramatic price increases.
Once the market is abuzz with news about the targeted stock, the conspirators will then start to dump their shares while the unsuspecting investors are still buying them at the artificially high price. This creates an artificial bubble which is quickly burst as the stock price goes back to its original level and the perpetrators reap the profits.
Modern Pump and Dump Tactics
While the basic mechanics remain the same, pump and dump schemes have evolved with technology:
- Social media campaigns: Scammers use platforms like Twitter, Reddit, Telegram, and TikTok to spread misleading information and generate hype around a stock.
- Email spam: Mass email campaigns touting "the next big stock" are a classic pump and dump tactic.
- Fake news sites: Some schemes create fake financial news websites or press releases to lend credibility to their claims.
- Cryptocurrency schemes: The same tactics used on penny stocks are now commonly applied to low-cap cryptocurrencies, which are even less regulated.
- Influencer promotion: Paid promoters may pose as independent analysts or investment experts to lend credibility to the scheme.
Is Pump and Dump Illegal?
Yes, pump and dump schemes are illegal in the United States as well as in many other countries. The U.S. Securities and Exchange Commission (SEC) has strict laws and regulations against this type of market manipulation, and any investors found to be participating are subject to civil and criminal prosecution.
Penalties can include substantial fines, disgorgement of profits, and prison sentences. The SEC actively monitors trading patterns and investigates unusual price and volume activity to identify potential manipulation.
How Can I Avoid Pump and Dump?
The best way to avoid getting caught up in pump and dump schemes is to be aware of some of the telltale signs:
- Be suspicious of promoters touting stocks that appear too good to be true.
- Do your own research before investing in any company. Review the company's financial statements, including its balance sheet and income statement.
- Always stay updated with the latest financial news and trends.
- Avoid investing large sums of money in penny stocks, as they are often the favorite target for pump and dump promoters.
- Be wary of unsolicited stock tips received through email, social media, or messaging apps.
- Check whether the company files regular reports with the SEC and has audited financial statements.
In any case, it's always best to rely on research and long-term investing principles such as value investing to develop a successful investing plan. Checking a stock's fundamentals, including EBITDA, free cash flow, and return on equity, is a good starting point when researching an investment.
Examples of Pump and Dump
Probably the most famous case of a pump and dump is depicted in the movie The Wolf of Wall Street, based on the real-life story of Jordan Belfort. Belfort was a stockbroker who manipulated penny stocks and misled investors by creating an artificial buying frenzy, then selling his own shares at a huge profit.
Another famous pump and dump scheme was carried out by Sam Israel III, which resulted in defrauding investors of over $400 million. Israel and his accomplices spread false information about Allied Automotive Group in order to lure investors and make a profit.
Another more recent case of pump and dump occurred in March 2020, when the SEC announced that it had shut down a $27 million cryptocurrency scam. The perpetrators had created fake press releases, websites, and social media accounts to persuade investors to purchase cryptocurrency through them. The SEC lawsuit eventually revealed that the defendants had made $3.7 million from the scam.