staircase illusion

What is Pump and Dump in Stock Trading?

Remember Jordan Belfort, of the blockbuster finance movie of all time, The Wolf of Wall Street, who swindled investors out of millions of dollars in a stock selling fraud scheme at his brokerage firm, Stratton Oakmont?

The scheme caught up with him and he was prosecuted and jailed for 2 years. He was also forced to pay back over $100 million to the investors he had swindled.

The stock manipulation strategy used by Jordan Belfort (Leonardo Di Caprio), is called the Pump & Dump scheme.

Belfort definitely goes down as one of the biggest crooks to ever pop up on Wall Street he is not the only in on it. Some of your favorite Wall Street CEO’s are still pumping and dumping stocks to illicitly earn millions of profits off unsuspecting Investors.

What is a Pump and Dump scheme?

Pump & Dump is one the oldest tricks in the books of corporate fraudsters. It is the illicit act of an Investor, group of investors, or company representative stealthily promoting a particular stock or mutual fund or any other type of securities in order to quickly sell at a profit when the price rises.

It is a form of corporate fraud where an individual investor, group of investors or an investment firm relentlessly promotes the stock of a company that they bought at a low price and taken a bullish position on.  

They then attempt to drive up the price of that stock through misleading or grossly exaggerated statements.

Typically the fraudsters will try to convince other investors to buy it by promoting it through e-mails, finance magazine publications, social media channels, newsletters, or online chat rooms to set up a media frenzy about the company.

They often back this up with some false or misleading ‘technical analysis’ or ‘insider information.’

Stock prices adjust based on laws of demand of supply. If a frenzy is successfully triggered by the fraudulent information in the media, and a lot of investors are looking to purchase the stock within a short period, the price will shoot up dramatically.

After this has been set in motion, the fraudsters will then offload their shares to the new investors who enter the market during the frenzy at a higher price, leaving them holding typically a worthless security by the time the frenzy peters out.

Channels Used to Carry out Pump & Dump Fraud

  • Press Statements
  • Social Media Buzz
  • Celebrity Endorsement
  • False Announcements/Projections
  • Fictitious Deals
  • Publishing Fictitious Financials

Pump and dump basically involve invoking an artificial frenzy through misleading the public with false statements or actions that could cause the price of the stock to rise.

The opposite of Pump & Dump is Poop & Scoop.  

This is a strategy by a group of short sellers to deliberately drop the market price of a stock or securities by making false negative claims about the company.

Pump & Dump Illustration

Let us assume that XYZ Corp. is a company with a market cap of $50 million and its shares are trading at the market value of $0.50 each.

Pump and dump fraudsters would purchase a large amount of the XYZ Corp. shares at this low price and would then would start promoting the stock via social outlets and press statements.

Prices can increase dramatically when the demand frenzy sets in.

As unsuspecting investors buy up the shares, the price surge as high as 300% to $1.50 per share.  At this point, the organizers of the pump and dump scheme start unloading their shares behind the scene, netting a quick and easy 250% margin (profits).

Eventually, the stock drops sharply to the ‘pre-pump’ levels. Thereby leaving duped investors with huge losses.

Why do Investors Run a Pump & Dump Fraud?

  • Quick Profit: 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 through the pump and dump fraud.
  • Merger & Acquisition Fraud: Some Company’s pump up their stock ahead of a merger deal with another company. This will enable the company’s top shareholders and executives to receive more money per-share of the actual market value during the takeover.

A company looking to buy up another company may also attempt to do a ‘Poop and Scoop’ on a company that they are trying to pay. In order to pay below the market value for its shares.

How to Avoid Pump & Dump Fraud

Now, having understood what a pump & dump scheme is, what can investors do to spot and avoid being victims of Jordan Belfort and other con-artists?

  • Be wary of news from unknown sources

Steer clear of relying on every press release statements, email newsletters, and other promotional materials to you by unknown sources typically containing information and ‘supposedly secret insider information about a stock.

Most times they are sent by paid influencers, promoters, or insiders with the singular aim of convincing people that a stock has a bullish potential.

Be especially cautious if your e-mail address is flooded with the same messages over a short period of time, particularly if the information only focuses on the assurances on the upsides of stock with no mention of any underlying risks.

  • Be wary of Penny Stocks

The relatively low prices of penny stocks make them the perfect targets for pump and dump fraud. Before investing in any penny stock, be sure to do your homework or contact a broker that is well specialized in the sector that the company operates.

  • Fundamental Analysis

Penny stock companies are relatively unknown companies and operating on smaller budgets. So it is unlikely that you find information about the company on large colorful websites, the front page of Wall Street Journal, or have the Company CEO on the Cover of Forbes.

This relative secrecy makes avenues for Pump and Dump fraudsters to perpetuate their activities. Ensure to do some research such as the Age of the company, its historical stability.

Make sure to know how long the company has been in business.  Pump and dump fraudsters often try to convince people that a new company is that ‘new kid on the block’ that is about to become massively profitable within a short period of time.

A brief google search of the company CEO’s or key promoters’ profile can also do you a world of good.

  • Examine Government Requirements:

It is crucial that you know whether the company has met all registration requirements and obtained relevant operational permits. If a company falls foul of a government requirement, the relevant agency may be tipped off on this (by the fraudsters). The company will get hit with heavy fines and operational sanctions, and it will cause the price of the stock to drop drastically.

  • Be Skeptical of Mergers

Be very cautious 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.

In a reverse-merger, a 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 clear picture of its risks, liabilities, financial assets, and some other legal details.

Reverse mergers often create a perfect opportunity for a schemer to perpetrate a pump & dump scam.

  • Avoid Stocks Listed On Unregulated Exchanges

Technical Analysis Guarantee nothing, Balance sheets, income statements, and cash flow statements can sure be cooked up or tweaked to present a larger-than-life image.

There are still many examples of pump and dump schemes involving companies that don’t file reports with the Canada Securities and Exchange Administrators.

Be vigilant, avoid buying stocks that are not listed on regulated exchanges such as the Toronto Stock Exchange and the Canada Securities Exchange 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 firm. Are the directors competent? Is the business well 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.

Conclusion

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 rampant due to the advent of the internet, social media, blogs, and other open sources of information

Investment advice such as stock tips may be convenient, but it is important to remember that are many wolves lurking and waiting to pounce on you.

Always endeavor to perform your own research on recommended stocks, or consult a broker before taking a stock position.

Leave a Reply

Your email address will not be published. Required fields are marked *