Pump and Dump Meaning
Pump and dump is a practice of artificially inflating the market price of a stock to gain by selling it before it falls again. It is an illegal activity as ruled by the Securities and Exchange Commission (SEC).
An investor or an investing firm engages in this activity by buying the stocks of a firm, the prices of which are easy to manipulate. It is then followed by excessive endorsing of that stock until it rises significantly. The investors then sell the stocks, thus making illicit profits, and the common investor loses their money.
Types of Pump and Dump Methods
- Traditional Scheme: This is a fraud scheme being followed since ages where the stocks are pitched through advertising, telephone calls, press releases, etc. to spread the misinformation. In such a scheme, the fraudsters pitch the stock by emphasizing that they have inside information of the subject stock.
- Wrong Number Scheme – Interestingly, this scheme is followed to trap a customer by telling him that he is not the target customer. Usually, on a telephone call, a fraudster spits out lucrative information about a stock to a customer and pretends to have made a wrong call instead. It generally leaves the customer baffled and somewhat lured for the stock.
Noticeably, these practices have been a subject of cinema in a few instances. ‘The Wolf of Wall Street’ and ‘Boiler Room’ are two such movies where strong references to this scheme can be found. In the latter, dishonest firms practiced selling penny stocks to customers by cold calling.
In this figure, it is evident that the stock price is being pumped to $15 from a modest $5. As soon as illicit profits are made, stocks are dumped back, thus causing a decline and sometimes even below the pre-pump level.
Examples of How Pump and Dump Work?
A former CEO of Jammin’ Java, a US company, was charged by the SEC for involvement in pump and dump practice where he had illicitly earned over US$ 75 million of profits. The CEO then engaged in fraudulent stock offerings and promotional campaigns to get a hike in the stock price. He not only ran a fraud campaign but also misused his previous position. SEC noticed that the management of Jammin’ Java realized the deceit when it observed a fall in stock prices a few days later. By this time, the dumping of the already inflated stocks had taken place, and huge profits were made.
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Such frauds come up with different schemes every time. The one mentioned in the example above came through a ‘reverse merger’ scheme. However, the underlying principle is the same every time – inflate stock prices fraudulently to gain profits.
Remarkable is the fact that such practices also aim at manipulating stock prices by taking the volume advantage. The investing party, through a reverse merger scheme, bought about 45 million shares of Jammin’ Java company before promoting it falsely.
Another notable instance of a pump and dump scheme happened way back in the early 2000s. In the dot com era, internet services for message boards were being used extensively. In one such case, Jonathan Lebed bought penny stocks and took the help of online message boards to promote these stocks. Lebed did this till the point the stock inflated so much so that he could make huge profits. Lebed made profits only to cheat the other investors. When SEC took notice of these activities, it charged Lebed of manipulating securities.
Such cases helped SEC strengthen regulations related to investing and securities while also making general investors beware of such activities.
Points to Note
- Pump and dump stocks is an illegal activity, and the consequences of such practices can be very dreadful.
- The party or parties practicing such schemes might pocket profits for shorter periods.
- No sooner than stock price turbulence comes in the notice of the concerned management, the scam alert is issued, and recovery processes are begun.
How to avoid being a victim?
Securities and Exchange Commission has issued certain tips for a general investor to practice caution while dealing with investing and trading securities:
- Investors should carry out their analyses during the process of investing. They can also hire/take the help of a financial planner, institutions, etc.
- Fake calls regarding investments can be identified by their sheer emphasis on significant returns and zero or fewer risk offerings.
- Investors should always consider tracing the source from where the “hot tips” are offered. More often than not, it leads to getting closer to authentic information.
- Most of these practices target small or mid-sized company stocks. Another target is the stocks trading in over-the-counter markets. It presents to investors a greater risk of being cheated; however, thorough research can mitigate the probability of risk.
- Always read and/or back up any investment decision by official reports issued by companies. The SEC filings like the 10K and the 10Q are common sources of getting the authentic information.
Pump and dump schemes can always be found in the markets in some ways or the other. In the past, it used to take the form of cold calling; in the era of technology, these schemes are based on emails, fake internet news, etc. Fraudsters will more likely target penny stocks and plot schemes in the OTC markets because they are less regulated. Such scams are very prevalent and can amount to over 15% of all the email advertisement on stocks.
Pump and dump sometimes become difficult to trace in comparison to other fraud schemes where there is a fraudster-victim contact in some form or the other. With regard to regulations, US regulators, including SEC, have tightened laws governing trade activities for penny stocks. However, it remains vital to good investing practices that an informed decision is made by conducting thorough analyses on the stock in consideration.
This article has been a guide to what is a pump & dump stocks and its meaning. Here we discuss how these types of pump and dump schemes work along with examples and explanations. You can learn more from the following articles –