Key Takeaways
- The practice of “pump and dump” refers to an attempt to artificially inflate the price of a stock or investment by spreading false, misleading, or exaggerated information about the security.
- Micro- and small-cap stocks are often the targets of pump-and-dump scams.
- There are severe penalties for anybody found guilty of operating pump-and-dump systems. There is a rise in the prevalence of pump-and-dump operations in the cryptocurrency market.
You must have come across Hollywood movies like Boiler Room and The Wolf of Wall Street showing Long Island brokerage companies of the 1990s that became notorious for organizing “pump and dumps”, which naïve wealthy clients fell victim to. In this article, we’ll discuss the concept of pump and dump, its different variations, possible scenarios in which it is practiced and how to avoid it. So let’s get started.
What is Pump and Dump?
Pump and dump schemes are a kind of securities fraud in which the price of a security is artificially inflated by the use of false, misleading, or exaggerated comments about the security. The perpetrator of the scam may cash in on the inflated security prices by selling his or her holdings fast at a high price.
However, the new owner of the shares stands to lose a significant portion of their initial investment since the security’s price will rapidly decline. Using the “pump and dump” method is unlawful.
According to securities legislation, this behavior is prohibited and may result in significant penalties. The popularity of pump-and-dump operations in the cryptocurrency business is a direct outcome of the asset class’s meteoric rise in popularity.
How it works
Microcap stock manipulation is a common tactic involved in pump and dump. These are equities from firms with a relatively low market cap. Typically, microcap stocks trade for pennies on the dollar (or less) on the OTC market. They don’t follow any of the rules for becoming public.
Thus, scammers may readily modify the securities information. Potential investors do not have adequate resources to evaluate all accessible information about a firm, which provides extra ideal circumstances for scammers.
Furthermore, microcap stocks are very illiquid assets with very limited trading activity. This means that even moderate trading activity may considerably drive up the price of an asset.
Fraudsters use techniques including cold calling, spam email, and fabricated press releases as part of a pump and dump scheme.
Types of pump and dump schemes
Classic Pump and Dump
Any strategy involving the manipulation of information about a company’s shares is considered to be part of the classic scheme. Phone-based stock pitches, false news releases, and the dissemination of “inside” information to artificially inflate share prices all fall under this category. Also, dishonest stock promoters might be hired to draw in more investors.
Boiler Room
The term “boiler room” refers to a kind of small brokerage company staffed by a large number of brokers that employ dishonest sales tactics to pitch investors on risky assets. By using cold calling, the firm’s brokers sell the penny stocks that they purchase and sell as a market maker. In order to increase the value of their equities, brokers operating in boiler rooms aim to sell as many shares as possible. Companies often sell their stock holdings for a profit after the stock price has increased.
Wrong Number
As with other variations of pump and dump, the “wrong number” strategy is relatively recent. A stranger’s voicemail with a “hot” investment suggestion to a buddy is something some people experience. The con artists want you to think that you received the voicemail because it was left on your phone by mistake. But it’s a calculated move made to increase interest in a certain stock among investors.
Additional pump and dump scenarios
Anyone with a trading account and the capacity to persuade others to purchase a stock that is “about to take off” may commit the same fraud. The schemer may set the ball rolling by making large purchases of a low-volume stock, which drives up its price. When the price rises, it encourages additional investors to buy, which drives the price even higher. The culprit might cash out their gains by selling their stock when they anticipate a drop in purchasing activity.
Pump-and-dump tactics have recently spread to the crypto market, too. The huge gains realised by Bitcoin and Ethereum have spurred immense interest in cryptocurrencies of every hue. Because of their technological complexity, lack of regulation in the cryptocurrency market, and general opacity, cryptocurrencies are unfortunately ideal for pump-and-dump schemes.
The frequency of pump-and-dump tactics in the cryptocurrency market was investigated in a report published in 2018. During the course of six months, researchers monitored two popular group chat sites among crypto speculators and uncovered over 3,400 such scams.
In March 2021, the Commodity Futures Trading Commission (CFTC) of the United States warned investors to beware of pump-and-dump schemes in unproven or hardly traded cryptocurrencies. The CFTC has announced a programmed that would reward whistleblowers with 10% to 30% of any financial fines of $1 million or more levied against a pump-and-dump operation.
“Pump and Dump” depicted in mainstream media
Hollywood movies centered on the pump-and-dump technique are not uncommon. In these films, you can see telemarketing stockbrokers peddle penny stocks. The brokerage business acts as a market maker in each instance and owns substantial amounts of shares in firms with very little growth potential. Company executives reward brokers with substantial commissions and incentives to encourage them to buy and sell the shares to as many customers as possible. By selling in such large quantities, the brokers are artificially inflating the price.
The company unloads its stock for a significant profit once the selling volume hits a tipping point and there are no more buyers. Eventually customers suffer significant losses since they are unable to sell their shares in time before the stock price drops below the initial selling price.
Recognizing and avoiding pump-and-dump scams
Avoiding falling prey to a pump-and-dump scam is easier with the aid of some advice from the Securities and Exchange Commission (SEC). Some considerations are as follows.
Be very cautious about investment opportunities that are unsolicited
If you get an unsolicited message about an “investment opportunity,” you should proceed with great caution. Due to the abundance of digital communication channels, you may get such questionable investment offers by email, social media remark, post, direct message, phone call, or voicemail. Put such letters in the trash; responding to them might lead to serious losses rather than the huge profits the fraudsters promised.
Keep an eye out for blatant warning signs
Consider if the promised investment’s benefits seem too good to be true. Do you get “guaranteed” large returns? Do you feel rushed to purchase immediately, before the stock skyrockets? Stock touts and dishonest promoters often use such strategies, and investors would be well to treat them as warning signs and go elsewhere.
Consider affinity fraud a serious threat
The term “affinity fraud” is used to describe financial schemes that target members of certain communities. Your trust in an investment pitch made by a fellow member of your group may be misplaced, since that person may have been duped into thinking the investment was safe while it actually is nothing more than a scam.
Investigate and check things out on your own
Take the time to do your own homework before investing your money. You can find out a lot about respectable businesses, including their history, management, and finances, by doing some research online. In many cases, the absence of such details is a red signal in itself.
Pump and Dump FAQs
Is a pump and dump illegal?
Pump and dump schemes are illegal under various securities laws in the U.S., as well as elsewhere, due to their deceptive nature and potential to cause harm to investors. Pump and dumps can also be used in fraud cases, particularly investor frauds.
What is an example of pump and dump?
An example of pump and dump would be if a group of people started spreading false rumors about a company in order to artificially drive up the price of its stock. The group would then buy the stock at the artificially inflated price, and then sell it once the price reaches its peak. This would result in large profits for those involved in the scheme, while other investors lose money. Pump and dump schemes often rely on social media platforms to spread false information quickly and widely.
What should I do if I am a victim of pump and dump?
If you have been the victim of a pump and dump, it is important to report the incident as soon as possible. You should seek legal advice from an attorney who specializes in securities law in order to understand your rights and options. Additionally, you may be able to recover some or all of your losses by filing a fraud claim with the Securities and Exchange Commission. Finally, in order to avoid becoming a victim of pump and dump schemes in the future, it is important to practice due diligence when investing and to be aware of any red flags or suspicious behavior.
Anti Pump and Dump laws have been put into place in many countries in order to prevent and prosecute this type of activity. Pump and dump schemes are illegal and carry steep fines, as well as potential jail time for those engaging in such activities. It is important to remember that if something seems too good to be true, it likely is. Pump and dump schemes rely on misleading information or false promises in order to deceive investors into buying a security, so it is important to do your own research and be wary of any suspicious activity.
What consequences can I face if I initiate a pump and dump scheme?
Pump and dump schemes are illegal and can carry severe penalties, including fines and potential jail time. Individuals who engage in pump and dump schemes may also be subject to civil lawsuits from investors they have harmed. Pump and dump schemes are considered securities fraud, which is a serious offense punishable by up to 20 years in prison and/or fines of up to $10 million. Additionally, individuals engaging in pump and dump schemes can be barred from the securities industry for life.
What are some pump and dump groups to avoid?
Pump and dump groups are often found on social media platforms or in private chat rooms and should be avoided as they can easily lead to fraud. Pump and dump groups typically spread false information about a company or security, which can result in investors unknowingly buying into a scheme. In order to avoid falling victim to pump and dump schemes, it is important to research any information or rumors that you come across and to be aware of any red flags, such as promises of quick or easy profits. Additionally, it is important to stay up-to-date on news related to the security you are considering investing in and to always practice due diligence when investing.
Final Word
In the 1990s, when boiler room frauds were at their peak, pump and dumps became increasingly common. They’re still very much alive. However nowadays, they tend to cluster in and around whichever sector is now riding high on the coattails of whatever passing trend may be. Be wary of any new OTC stocks that promise to offer exponential gains in the stock market’s darling industry.