Pump and dump in the stock market refers to the unethical practice of inflating the share prices by hyping people to make a purchase that drives the demand, only to later sell it booking the maximum profit. Due to this, many naive investors end up bearing huge losses. Pump and dump artists are known to have purchased the stocks of a particular company for a lower price.
Various tricks are used to attract investors, generally, the ones who are a part of the herd and follow rumors regarding the prospect of an increase in the share prices. Investors who lack financial knowledge start purchasing the stocks of that company. As the demand keeps increasing but there are no sellers present, the stock prices skyrocket which is known as ‘Pump’. The value of the company will have crossed its intrinsic value however, it is a result of the pump and dump scheme. The scheme artists hold their stocks up to the point where they can derive the maximum profit and then begin selling their stocks which is known as ‘Dump’. The seller rush results in the stock price taking a huge downward leap and the investors who bought the shares at extremely high prices are dumbfounded.
Pump and dump scheme targets microcap (penny) stocks which refer to companies with a relatively smaller market capitalization. Relatively a small number of buyers can raise the stock price which makes an easy way for the perpetrators to carry on with the manipulation. Aggressive stock promotion schemes result in an artificial price hike which is said to follow the law of gravity all the time.
One of the earliest pump and dump involved Radio Corp. of America (RCA), a tech company which was trading for less than $100 before its price inflated to more than $500 as a result of investors known as “Radio Pool” buying and selling stocks amongst themselves. One of the investors named Michael J. Meehan sold 200 of his shares for $94.50 per share. The same number of shares were sold for $95 by his friend to another friend. The very next day the price rose to $96 then $97.50 and finally, Meehan bought his original shares for $98.25 each. Initially, one could observe an increase in volume of trade because the trade did occur although things were being manipulated. Within a month of the opening, RCA was being sold for $195 which was up by approx. $100 since its opening. This bullish trend made investors hop into this trend and buy the stocks in a hope to get rich quickly. The prices inflated more than $500 before the stock market crash in 1929 after which the prices dropped to $10 per share. Investors who sold their position benefited, however, people who were scammed through artificial growth had to bear huge losses.
According to “Investor’s handbook on Securities Markets and Commodity Derivatives Markets” published by Securities Board of Nepal, pump and dump is an illegal activity as per the securities law and can lead to heavy fines. It categorizes pump and dump under undesirable activities of the markets and states that developed capital markets require proper regulations in order to prevent such undesirable activity that distorts the market efficiency.
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How To Identify A Pump And Dump Scheme?
There are certain ways we can identify a pump and dump scheme and prevent ourselves from being a victim of such manipulation, some of which are as follows.
1. Inorganic Growth
If high trade volume has led to an increase in stock prices, it can be classified as an organic growth. However, if the stock prices have risen with low volume of trade, this denotes a manipulation scheme and buyers are suggested not to take a buy position. Therefore, if the volume does not support market growth, it is most likely a pump and dump scheme. There wouldn’t be a definite reason or news as to why this has happened. The stock prices could drop the way it has risen in no time.
2. Spam Email
One must be careful of the spam emails he/she receives. A legitimate company will always use official channels to deliver messages to the public. Therefore, one should always ignore investment pitches sent in the spam section of the email because it is likely to be false.
3. Purchase Pressure
You must not be pressured upon hearing things like “If you don’t buy now, you regret later”, “Now or Never”, “You’ll miss the train” and many more. One thing to remind yourself is that a good company does not need such publicity. So, whenever a stock is overhyped, know that this is a tactic to bring in more buyers that will stimulate demand and increase the stock prices.
4. Stock Recommendations on Social Media
There are numerous groups as well as pages dedicated to people interested in the stock market in social media. Investors can gather as well as share information whenever they want to. It gives an equal opportunity to fraudsters to share false information in order to manipulate the investors. It does not take much time for people to create fake accounts and pitch for stocks that they have purchased. It has indeed become the most common source for causing a stir in people’s perception. There are people bragging about how good of an investment they bagged and paid-promoters to hype a particular stock. Thus, you should not fully rely on the information present on social media since they can be easily manipulated.
5. Intense Touting
Touting a stock means being persistent in making the investors buy stocks of a particular company. Emails are sent under a free subscription touting service. You might have come across several pages asking you to sign up for weekly newsletters or daily dose of information. Emails sent repeatedly signifies that the spammers have not achieved the volume they were targeting. Stock promoters own several sites like this and all of them tend to promote a particular stock in order to influence the purchase decision of the buyers. Losses are greater for stocks touted aggressively. Volume responds positively and significantly to touting. Spammers tout stocks to increase demand and eventually the price, enough to unload the stocks they’ve held at a profit. Therefore, one should avoid heeding advice in stock-touting emails.
6. Lack of Financials
A legitimate company will always have its financials available to the public on its website which can be used to know the financial position of the company. Now it is important to compare the assets of the company with the market capitalization of stock. A company with less money in the bank having a worth of millions or billions is questionable. Therefore, if a company does not have its recent financial statements accessible to the public, it is an alarm for the investors wanting to invest in the company or holding position in the company.
7. Background of Top-Level Management Employees
One can always check the qualifications of people who govern the company which makes us aware of their eligibility (can be found in the prospectus published by the company). Moreover, we can investigate their past involvement in public companies and scan the performance of such companies. If they’ve been involved in pump and dump schemes in the past, then it could be a sign for you to beware of where you are investing for a crime committed once doesn’t guarantee that the person is not going to do it the second time.
8. Claims of breakthroughs
You must be careful when a company claims to be an industry leader or has made a breakthrough discovery. A genuine company does not need to incline towards touting stocks if it has indeed made such an important discovery. It is quite skeptical that a mere starter in a certain sector is claiming to be an industry leader. Let the work speak for itself. Do not get intimidated by groundless claims. Try to look for how long the company has been in business. It is easy to fool investors by speaking highly of a young company being able to generate profitable returns in a short span of time in order to persuade the investors.
9. Share Buyback
Buy back is often carried out to reduce the number of shares outstanding in the market. The major reason for a company to buy back its shares is because it believes its shares to be undervalued. Reduction in the number of outstanding shares increases the company’s earnings per share ratio, attracting the investors. The insiders could also be trying to show that they have earned a good amount of profit to be able to buy back their shares. However, it could be a trick of the insiders to further success a pump and dump scheme. Therefore, do not simply invest in a company because it has made announcements regarding buy back of shares.
10. Reverse Mergers
Reverse merger refers to a private company going public by merging with an existing public company. The private company wanting to go for a reverse merger need not submit some crucial documents which wouldn’t have been the case if it issued shares to the public through an Initial Public Offering (IPO). This means the investors interested in purchasing the stocks of such a company will not have an opportunity to know the potential risks, level of assets and liabilities and other matters that are important to take the purchase decision. Thus, reverse mergers create a perfect environment to carry on with a pump and dump. Investors should therefore be skeptical regarding reverse mergers.
Lastly, the most efficient way to protect your investment is to gain knowledge on what the stock market is, how it works and the basics of investing. Invest in some great investment books. If you’re new to investing, stick to reputable investment firms who do not force you to make particular investments. And the most important, always follow business trends and not pop culture trends. Pop culture trends might seem undeniably captivating and might be the talk of the town however, simply because it is popular today does not guarantee its popularity in the long run. Therefore, do your own research instead of being a part of a herd that functions upon hearing rumors.
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