A pump-and-dump is the term used when an asset sees a sharp price increase (pump) followed by an even more dramatic price decrease (dump). Pump-and-dump schemes usually involve a group of investors who get into an asset early and then persuade many other investors to make purchases and drive up the price. Then, at some point, the original investors “dump” most or all of their holdings into the market, creating a crash. The investors who were not first in on the trade wind up taking substantial losses.
How Does a Pump-and-Dump Scheme Work?
Almost anyone can conspire to create a pump-and-dump. It could be a group of large investors, social media influencers, or a dishonest team behind a company or cryptocurrency project. Pump-and-dump schemes are made up of two phases.
The first phase focuses on spreading misinformation to boost an assets price beyond it’s real value, while the second phase shifts into a selling mode, where original investors shed their shares for high profits.
Pump-and-Dump Scam Phase One
In the first phase, a group of investors trying to get other investors to buy a security by spreading false or misleading information about it.
Imagine hearing, “Buy this stock and become a millionaire overnight, it’s going from $0.50 to $500 because of something that’s about to happen!”
Meanwhile, the investors spreading the misinformation already bought shares at a low price.
Pump-and-Dump Scam Phase Two
Once enough new investors have been convinced to buy the stock, the second phase of a pump-and-dump scam begins.
After waiting for the price to rise to unreasonable levels, the original investors begin selling shares. This causes the price to fall significantly, possibly inducing others to sell as well. The investors who got in late wind up taking heavy losses.
Is a Pump-and-Dump Scam Illegal?
Pump-and-dumps are illegal in the stock market. The U.S. Securities and Exchange Commission (SEC) often prosecutes people who initiate these types of stock scams.
The cryptocurrency market, however, often falls into a legal grey area. Because most cryptocurrencies are not classified as securities, regulators don’t always have the legal grounds to charge scammers in the first place.
However, there are some signs that this has begun to change, as cryptocurrency goes more mainstream.
In October 2020, John McAfee was charged with illegally promoting initial coin offerings (ICOs) in exchange for cryptocurrency payments. And some social media platforms have begun restricting influencers who promote particular cryptocurrencies.
How Can You Spot a Pump-and-Dump Scam?
There’s no hard and fast rule for figuring out if an asset is being used for a pump-and-dump scheme, which means investors have to use their own best judgment and do their own research when deciding to buy a stock.
The biggest indication of a pump-and-dump scheme might be the excessive hype built up around a project or company. When there seems to be an extraordinary amount of optimism around an investment for no good reason, or for reasons that don’t quite make sense, it could raise a red flag—and potential investors may want to investigate further.
Another indication of a pump-and-dump scam at play is the meteoric rise of stock prices in short periods of time in assets that were previously unknown, forgotten, or ignored.
Most often—absent some sort of stellar news or industry breakthrough—stocks of legitimate companies take time to come into their valuations. Although nothing goes up in a straight line they typically tend to rise steadily along the way.
When someone writes a marketing email or social media post using phrasing like “this company is the next huge thing,” and the price quickly rallies as if everyone believes this to be true, it could possibly be a pump-and-dump.
How Can You Avoid Pump-and-Dump Stocks?
The simplest and most assured way to avoid pump-and-dump stocks would be to stick to popular stocks and ETFs with very large market caps. The larger the market cap of a stock, the more capital would be required to initiate a pump and dump, decreasing the likelihood of such a thing happening.
According to Investor.gov , a site established by the U.S. Securities and Exchange Commission (SEC), micro cap companies are especially vulnerable to pump-and-dump scams because there’s often less information published about small, lesser-known companies. A smaller market cap also makes it easier for a group of investors to “pump” the price, as less capital would be needed.
Other ways to avoid falling victim to a pump-and-dump stock or crypto scam involve sticking to trusted sources of financial information. Learn to analyze a stock on your own, rather than relying on content hyping a particular investment, such as investment newsletters, marketing emails, and social media. Most reliable sources refrain from hyping any particular asset or security because they know it could get them into legal trouble.
Are All Penny Stocks Pump-and-Dump Stocks?
The umbrella term “penny stocks” is generally used to refer to micro cap stocks with a share price of less than $5. While pump-and-dump schemes are likely common among penny stocks, not all of them are pump and dump stocks. Many are legitimate companies that are new and still growing.
Generally, there are two places investors might be most likely to stumble upon a pump-and-dump asset:
• Small cap stocks
• Small, new cryptocurrencies
Are All Altcoins Pump-and-Dump?
Pump-and-dump schemes can be more common among smaller altcoins. Some have been targeted for this purpose in the past.
During the initial coin offering (ICO) boom of 2017 and 2018, countless pump-and-dump schemes took place in the altcoin markets. Some of them didn’t even have legitimate software projects behind them — they were created for the express purpose of hyping a coin so that the creators could sell at a high price.
Even today, many altcoins that have been around for years but have seen their prices collapse by 90% or more can fall victim to pump-and-dump schemes.
The Takeaway
In a pump-and-dump scam, one group of people conspire to pump up the price of an asset so they can dump it on unsuspecting investors. Anyone can start a pump-and-dump scheme, and anyone can fall victim to one. Typically, small cap stocks and newer, smaller altcoins are especially vulnerable to pump-and-dump scams, though any stock or crypto could fall victim to a scheme.
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