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 stocksSmall-cap StocksSmall cap stocks are offered by relatively small companies that are publicly listed. A small cap company has a low market capitalization ranging between $300 million to $2 billion. Small cap investors have a high-risk, high-reward approach. are more prone to this scam, and investors must exercise caution around suspicious hypes.
Table of contents
- 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.
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. 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. are prone to manipulation as there is limited information about them. Microcap and penny stocks have small market capitalizationMarket CapitalizationMarket capitalization is the market value of a company’s outstanding shares. It is computed as the product of the total number of outstanding shares and the price of each share. 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.
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Pump and Dump: Explanation in Video
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., 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.
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 cryptocurrenciesCryptocurrenciesCryptocurrency refers to a technology that acts as a medium for facilitating the conduct of different financial transactions which are safe and secure. It is one of the tradable digital forms of money, allowing the person to send or receive the money from the other party without any help of the third party service..
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 –
- The SEC and other regulatory bodies come up with tips, advisories to prevent being conned. As an investor, it is essential to go through them from time to time.
- Also, watch videos, ask for help and educate yourself about the stock marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price. before investing.
- If you are confused, try external help from trusted people who are brokers, long term investors and have spent considerable time in the stock exchanges.
- Whenever there is a hot piece of information regarding any stock, try tracing its source, checking, rechecking, double-check, and authenticating it before making any decisions.
- Try to identify fake calls and emails, especially around microcap stocks. Check their accuracy by speaking to third parties who hold knowledge about the matter.
- Focus on finding any reports or official announcements of the company. Try to collect as much information as possible about the stock.
- Keep yourself away from spammy messages or report them to the SEC.
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.
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.
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.
This article has been a guide to what is a Pump and Dump & its meaning. Here we discuss the process & legality of pump & dump schemes using stock & crypto examples. You can learn more from the following articles –