Pump and Dump Simple Explanation

Jul 21, 2020 03:35 AM ET
Pump and Dump Simple Explanation

What is the Pump and Dump Scheme?

Pump and Dump schemes are an illegal, yet prevalent practice in the modern digital trading world, where an investment influencer, an individual or an investor group inflates the prices of particular stocks they hold, artificially. They may already hold a large volume of the stock and convince other investors to purchase it. The group or individual behind the pump and dump scheme then rapidly sells their shares at a higher price once the share prices increase. This triggers a sharp price drop, leaving investors with stocks worth much less than what they earlier paid for it. 

The individuals or investors who partake in these schemes usually target micro-cap or penny stocks. They can easily influence the stock price as it requires considerably less capital infusion from outside investors. They then promote the stocks to other investors as a “hot” investment idea, which price is about to increase. Traditionally this took place in “boiler” rooms over the phones, or through physical mail. Nowadays, however, it takes the form of spam emails or scam telegram channels, commonly. If the promotions entice outside investors, they also purchase the stock, causing a rapid price increase based not on business fundamentals but rather on hype and demand. 

Investors then sell their shares at a profit once the stock price rises, which triggers a rapid drop in the stock price as a result. Investors who were earlier convinced to purchase the stock now embark on panic selling, further decreasing the stock price even more. Eventually, investors have left holding shares that are worth far less than what they got it for. 

Pump and Dump Simple Explanation

How to Find a Pump and dump stock?

  • Unexpected quasi good news: The participants of the scheme promote their stock using some unexpected quasi good news about a particular stock to entice other investors. They may use phrases such as “having inside information” and “about to hit the stratosphere” to hype up their stock. They often present some metrics to justify their claim. Unsuspecting investors often fall into this trap and buy into the scheme. 

  • Big volume, gap, or significant move: Investors should check the volume chart for any stock they suspect to be part of a pump and dump scheme. One of the tell-tale signs for pump and dump schemes is a significant jump in trading volume from nearly zero to and extremely high number. This usually happens at the start of the price rise. Although there are cases where this is not caused by a pump and dump scheme, checking these parameters would provide more information to the investor to confirm whether a stock is indeed a part of a pump and dump scheme. 

  • Stock shares float under 10 million: The small amount of the shares traded can easily move the stock price up a hundred percent. The full amount of shares can change its holders several times a day, “thanks” too low liquidity. That helps manipulators to create a synthetic move in a stock and sell it to their “victims” at the significantly overbought price 

  • The company barely looks like a normal business: Investors should conduct detailed research on the company they suspect to be a part of the pump. They should rely on basic fundamental indicators and the resources they have to evaluate the company’s value. Generally, the business fundamentals of the companies that are part of such schemes show that their shares should be valued at close-to-nothing prices. Permanent losses in financial reports, a low number of employees, a suspicious website, and a significant number of stock-splits is indicating that the promotion is likely false and the company is close to being bankrupt. 

How to Benefit from Pump and Dump

  • Avoid: Investors should always be on the lookout for any unsolicited stock whose prices are about to go off. These stocks may be tempting to an investor, especially their profit potential. Investors should thus check the background and the source, looking out for any red flags present.
    Promoters or insiders of the pump and dump schemes usually promote it through bulk emails or newsletters. If such emails only talk about the hype and do not mention any of the risks involved, it’s highly likely that it’s a scam. Before making an investment, investors should always conduct research on their own. 

  • Long the Pump: Traders can get in early enough to avoid the sell-off for going long. Investors should search social media and stock forums to look for stocks with the most hype which shows the signs of being in a pump and dump scheme. They should wait for the stock to gain a significant percentage (100% or more). Increases like these are not a long-lasting phenomenon. After the stock has indeed moved up that much, traders should look to buy in on the next day on a break of the first day’s highs. They then have to prepare to sell their position via short term moving average to keep their profits. The rallies usually last around one to five days. 

  • Short the Dump: Shorting the dump, or shorting the selloff is one of the quickest ways a trader can make money but does require significant skill. They have to scan for stocks that are starting to break. However, there is always the chance that the traders short too early.
    They should also be careful while shorting as they can suffer a loss if the high demand for the stock causes the broker to call back the borrowed shares before the dump begins. The perfect short signal is the extremely high volume (the biggest volume from the beginning of the pump) combined with the reversal candlestick pattern. That usually means that “insider sellers” stepped in to fix their profits.

The Bottom Line

Traders can gain substantial profits if they play their cards right while trading pump and dump schemes. However, traders and investors should never forget that pump and dump schemes carry a high degree of risk. It can be extremely dangerous for those investors who are too slow to recognize what’s happening, suffering heavy losses after the dump occurs. 

Identifying a pump and dump scheme can be difficult at first. However, conducting a little research into the promotional team’s background as well as information about the stock in question can go a long way in protecting one’s self from inflated hype. Traders should always approach the stocks they suspect, with skepticism.  Regardless of the risk involved, it can be a tremendous opportunity for traders to earn a significant profit in a short period of time, if they’re willing to take the risk.


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