Pump and Dump

What is Pump and Dump?

Pump and dumps refer to the scam of raising the price of vulnerable stocks using misleading promotions and selling off the shares once their price booms. After voluminous selling and the hype wearing off, the share price dips sharply, leaving many investors in heavy loss.

The Securities and Exchange Commission (SEC) penalizes pump and dump offenders as it is an illegal practice. Small-cap stocks are more prone to this scam, and investors must exercise caution around suspicious hypes.

Key Takeaways
  • Pump and dump is the practice of fraudulently boosting a company’s share price and exiting the market with a massive profit before the price declines.
  • It is an illegal and unethical practice with the Securities and Exchange Commission (SEC) often punishing the offenders. There are many laws under which the authorities book a perpetrator.
  • Many unsuspecting investors fall victim to this scam and invest in an otherwise under-performing stock. Later, they face colossal loss when the stock price declines heavily.

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How do Pump and Dumps Work?

A pump and dump scheme feeds on the desire to make profits from stocks and crypto trading. It lures clueless investors by portraying a mediocre stock as highly profitable. The process starts when some shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.read more of an ordinary stock indulge in its false publicity.

They keep hyping the company as the next big thing using fake news, false reports and misleading statements. Unsuspecting buyers invest in the firm thinking that the stock will grow in future. Frenzy buying pumps up the stock price. The originators of the scheme start selling the shares or dump them to pocket hefty profits.

With voluminous dumping and the hype ending, the share price declines sharply. Consequently, many investors incur a severe loss. The price hardly ever takes off again as the stock’s value was artificially boosted without genuine growth. The scheme is hence illegal and punishable by law.

According to the SEC, microcap stocksMicrocap StocksStocks with a market capitalization of $50 million to $300 million are known as micro-caps. The market capitalization of such stocks is higher than that of nano-cap firms, but lower than that of small-cap, mid-cap, and large-cap companies.read more are prone to manipulation as there is limited information about them. Microcap and penny stocks have small market capitalization and are not usually obligated to share performance report like NASDAQ stocks. It allows ample avenues to harbor rumors with not much to cross-check.

Example

Luke and Lucas are stock market investors. Lucas buys 1000 shares of a company for $5, a total investment of $5000. He then starts spreading fake news that, as per inside informationInside InformationInsider Information is a piece of fact, information or an understanding (M&A, New Contracts, R&D breakthrough, new product launch etc.) which could impact the prices of a listed entity or publicly-traded organizations once disclosed in the public domain. Trading based on such information is considered to be illegal.read more, the firm is turning into a public sector entity due to outstanding performance.

Soon, the stock price goes up to $30 in three days. Luke observes that the price is going up. He buys 1000 shares of the company at $30 each, taking his investments to $30000.

Soon, the share price rises to $50 a share. Lucas decides to exit the market to pocket profits. He sells all of his shares and makes a profit of $45000. With the rumors ending and no substantial growth, the share price slides down to $5 a share. While Lucas swims in his profits, Luke goes into debt.

Real-World Examples

Financial news is usually loaded with examples of pump and dumps. Novice investors with no profound exposure to stock knowledge fall victim to the fraud, fearing losing a golden opportunity.

Spammy phones calls and pamphlets were a traditional favorite for scamming. Gradually, fraudsters with access to online trading started using emails, social media, and chat rooms etc., to spread misinformation. Typically, scammers promote using spammy messages.

In January 2021, individual investors drastically boosted GameStop’s share price from $20 to $483 in two weeks. In February, GameStop’s shares fell almost 90 per cent to $53.50. Federal authorities suspected price manipulation and were reported to be investigating the buying frenzy for any signs of stock price manipulation.

Cryptocurrency isn’t far behind when it comes to pump and dump schemes. In 2021, prosecutors accused John McAfee, the founder of the renowned anti-virus company, of raking in millions by allegedly manipulating the market price of some cryptocurrencies.

Are Pump and Dumps Illegal?

As discussed above, stock price manipulation using misleading information is a scam that often steals the victims’ hard-earned money. Hence, it is considered illegal under various laws and acts. Laws such as the Securities Act of 1933 and the Securities Exchange Act of 1934, etc., contain segments to criminalize misstatements and frauds related to securities.

Depending on the case, there are other laws as well that can penalize an offender. The SEC stays vigilant to spot any instance of stock price manipulation. The regulatory body keeps charging the offenders to ensure the safety of innocent investors who bear the brunt of manipulation. Many government bodies also provide an anonymous platform to report offenders.

Ways to Tackle

Many stock market experts have discussed how to spot stock price manipulation. As investors lose a lot of money to price manipulation, they should know how to spot and avoid it. Following are some ways to achieve the same –

FAQs

Is a pump and dump illegal?

Yes, pump and dumps are illegal under many laws, such as the Securities Act of 1933, as it leaves innocent victims with heavy financial losses. Regulatory bodies keep a strong watch on any instances of price manipulation and penalize the offenders.

Why are pump and dumps bad?

They involve artificially boosting a stock price using false information. The rise in price does not come off a genuine growth; they fall soon enough when the manipulation ends, making many investors lose all their money.

How do you know if it is a pump and dump?

Suppose there is a sudden overdose of emails, social media hypes, or phone calls, especially around a mediocre microstock, urging to invest immediately to reap more significant benefits – in that case, it is likely a pump and dump.

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