What is Pump and Dump? How does it work?

A pump and dump scheme is a kind of securities fraud that includes artificially inflating (or “pumping”) the price of a security by the use of representations that are false, misleading, or overstated in reference to the price of the security. The scammer can profit from the price inflation by selling the securities fast at a high price (“dumping”) in order to generate a rapid profit.

As a result of the rapid decline in the price of the security, the new owner of the shares will almost certainly see a significant portion of the cash that they invested evaporate. The practice of pumping money into an account before immediately draining it is prohibited.

Working of Pump and Dump schemes

The desire to increase one’s wealth through stock trading or cryptocurrency trading is the motivation behind a pump and dump scam. It portrays a poor stock as being very profitable, which attracts investors who are not very knowledgeable. When certain shareholders of an ordinary stock participate in the stock’s deceptive publicity, the process might be said to have begun.

They continue to promote the firm as the next great thing by employing fabricated news, fraudulent reports, and remarks that are intentionally deceptive. Investors who do not have all the facts invest in the company under the impression that its stock would increase in value in the coming years. The stock price was driven higher by a purchasing frenzy. The people who came up with the concept begin to sell the shares or dump them so that they may earn substantial profits.

The massive selling that’s been going on combined with the fact that the hype has died down has led to a significant drop in share price. As a direct consequence of this, a significant number of investors suffer a loss. As a result of the value of the stock being artificially inflated without being supported by true growth, the price almost never recovers and begins to rise again. Because of this, the strategy is unlawful and may result in legal penalties.

Check also: How to come up with the best trading strategy?

Different types of Pump and Dump Schemes

Fraudsters have a variety of options available to them when it comes to the sorts of pump and dump schemes they might use. The following are some examples of them:

1. The time-honored pump and dump strategy

The traditional plan may entail any sort of information manipulation concerning a corporation and its shares. It may involve stock pitches over the phone, the distribution of bogus news releases, and the giving out of some kind of “inside” knowledge that might increase the price of the stock. In addition, dishonest stock promoters’ services may be utilized in order to draw the attention of investors to the stocks in question.

2. Boiler room

A “boiler room” is a term used to describe a very small brokerage business that employs a number of brokers that engage in unethical sales methods in order to offer investors dubious assets. Through the use of cold calling, the brokers sell penny stocks, which the company also acts as a market maker for and buys and sells. The stock brokers who operate in boiler rooms make it their goal to sell as many shares of stock as they can, which drives up the price of the stocks. When there is an increase in the price of the stock, the company will sell its shares of the stock in order to realize a profit.

3. “Wrong number” scheme

The “wrong number” technique is a fresh take on the pump and dump strategy. There is a possibility that some individuals will get voicemails from complete strangers offering a “hot” investment suggestion to a buddy. The con artists want you to assume that the message was unintentionally left on your phone, so they can steal your money. On the other hand, this is a focused move to attract the attention of potential investors to a particular stock in order to build demand for this stock.

How to stay clear of pump-and-dump schemes

Understanding how pump-and-dump scams operate is the greatest way to prevent falling victim to one. Here’s how to spot these con games and stay away from them.

Understand what to search for

Various investment kinds are susceptible to pump-and-dump tactics. Always conduct research to make sure you are investing in a reputable product.

For instance, if you’re thinking about investing in a hot, new cryptocurrency, do your homework on the project’s creators and any good or service being promoted to investors. Seek out reviews on independent sources to see what others are saying about the project. Consider making a different investment if you have any concerns about the investment’s validity.

Do you think it makes sense?

Pump-and-dump strategies sometimes rely more on hysteria and speculation than on ethical trading or business standards. For instance, the attitude supporting a specific stock might not be very logical. Even if the business may be losing money or making little money, the stock price suddenly rises. If you are unable to provide an explanation for why the price is increasing, it may indicate that the price is excessive or that you are considering a pump-and-dump technique.

Use your common sense

Keep in mind that when you invest, you’re making a wager on the company’s future. Be cautious of businesses that are not yet profitable and explore why you would want to invest in them.

Additionally, it’s crucial to keep in mind that stock prices fluctuate. When considering a stock with a high price, bear in mind that prices might fall and that you could suddenly incur losses.

Take a look at the source of the buzz

Pump-and-dump schemes rely on exaggerated urgency and excitement. A third entity, such as a newsletter or social media account, frequently creates excitement. If you’re considering an investment and the promoter isn’t someone you can trust, the scheme can be a trick.

Research before making an investment

Pump-and-dump scams depend on investors who are ready to hold out hope that the price of a stock will increase. You may determine if a stock is most likely to be a good or bad investment by conducting your research.

To determine whether a firm is profitable and growing, look at its financial records and earnings reports. To assess how successfully the firm can compete, you need also consider the competitive environment.

Indicators of a possible pump-and-dump scam include excessive valuations or a lack of profitability, so keep an eye out for them.

Read also: Tips for the beginner crypto investor