What is a ‘Pump and Dump’ in the stock market?
In the stock market, pump and dump refers to the unethical practice of raising share values by encouraging people to make a purchase that generates demand, only to later sell it for the highest profit. As a result, many inexperienced investors suffer massive losses. Pump and dump artists are known to have purchased a specific company’s stock at a cheaper price.
Various tactics are employed to entice investors, who are often part of the herd and follow rumors about the possibility of an increase in share prices. Investors with limited financial expertise begin purchasing the company’s stock. As demand grows but there are no sellers available, stock prices surge, a phenomenon known as ‘Pump.’ The company’s worth will have surpassed its intrinsic value, but this is due to the pump and dump technique. The scheme artists will retain their stocks until they can make the most profit, at which point they will begin selling their stocks, a process known as dumping. The seller rush causes the stock price to plummet dramatically, leaving investors who purchased shares at exorbitant prices perplexed.
The pump and dump plan focuses on microcap (penny) stocks, which are companies with a modest market capitalization. A relatively small number of buyers can raise the stock price, making it simple for the culprits to continue the manipulation. Aggressive stock promotion strategies result in an artificial price increase that is believed to always obey the law of gravity.
One of the first pump and dump schemes was Radio Corp. of America (RCA), a technology company that was trading for less than $100 before its stock price soared to more than $500 as a consequence of investors known as the “Radio Pool” buying and selling stocks amongst themselves. Michael J. Meehan, one of the investors, sold 200 of his shares for $94.50 per share. His acquaintance sold the same amount of shares for $95 to another acquaintance. The next day, the price jumped to $96 then $97.50 before Meehan purchased his original shares for $98.25 each. Initially, there was an increase in the volume of trade since transaction did occur despite the fact that things were being controlled. Within a month of its debut, RCA was selling for $195, a price that had risen by around $100 since its debut. This positive trend enticed investors to jump in and buy stocks in the goal of becoming wealthy rapidly. Prices had risen by more than $500 before the 1929 stock market crash, when they fell to $10 per share. Investors who sold their positions prospered, but those who were duped by fake growth had to face massive losses.
Pump and dump is a prohibited action under securities law, according to the Securities Board of Nepal’s “Investor’s Guide on Securities Markets and Commodity Derivatives Markets,” and can result in substantial fines. It categorizes pump and dump as undesirable market behaviors and asserts that established capital markets require suitable laws to prevent such undesirable market behavior that undermines market efficiency.
How Do You Spot A Pump And Dump Scheme?
There are several ways to spot a pump and dump scheme and avoid becoming a victim of such manipulation, some of which are included below.
1. Organic Development
If increasing trade volume has resulted in an increase in stock prices, this is considered organic growth. If, on the other hand, stock prices have risen with a limited volume of activity, this indicates a manipulation scheme, and purchasers are advised not to initiate a purchase position. As a result, if the volume is insufficient to support market expansion, it is most likely a pump and dump plan. There would be no specific cause or news as to why this occurred. Stock values could plummet as quickly as they have climbed.
2. E-mail Spam
One must exercise caution when receiving spam emails. A genuine business will always use official methods to communicate with the public. As a result, investment pitches made in the spam part of an email should always be ignored because they are likely to be fake.
3. Purchase Influence
You should not feel pressed if you hear phrases like “If you don’t buy now, you’ll regret it later,” “Now or Never,” “You’ll miss the train,” and others. One thing to keep in mind is that a good company does not require such publicity. So, whenever a stock is overhyped, realize that it is a ploy to attract more purchasers, which will stimulate demand and raise stock prices.
4. Social Media Stock Recommendations
On social media, there are countless groups and pages dedicated to persons interested in the stock market. Investors can obtain and share information at their leisure. It provides equal opportunity for fraudsters to disseminate fake information in order to defraud investors. It doesn’t take long for people to set up bogus accounts and pitch for stocks they’ve purchased. It has become the most popular source of making a stir in people’s perceptions. There are those gloating about how excellent of an investment they got, as well as paid promoters who hype a specific stock. As a result, you should not rely solely on the information available on social media because it is readily altered.
5. Extensive Propaganda
Touting a stock entails persistently convincing investors to purchase stock in a specific company. Emails are distributed as part of a free subscription marketing service. You may have come across multiple pages requesting that you sign up for weekly newsletters or a daily dose of information. Emails sent repeatedly indicate that the spammers did not obtain the volume they hoped for. Stock promoters operate multiple sites like this, and they all tend to push a specific stock in order to influence customers’ purchasing decisions. Losses are bigger for stocks that have been aggressively promoted. Touting has a good and considerable impact on volume. Spammers promote stocks in order to boost demand and, eventually, price, allowing them to sell the stocks they’ve held for a profit. As a result, one should avoid taking advice from stock-touting emails.
6. Inadequate financial resources
A reputable corporation will always make its financials available to the public on its website, which can be used to determine the company’s financial situation. It is now necessary to compare the company’s assets to its stock market capitalization. A corporation with less money in the bank and a value in the millions or billions is suspect. As a result, if a company does not make its most recent financial statements available to the public, it is a red flag for investors looking to invest in or keep a position in the firm.
7. Top-Level Management Employees’ Backgrounds
One may always examine the qualifications of the people who run the company, which informs us of their eligibility (can be found in the prospectus published by the company). Furthermore, we may look at their previous involvement in public companies and analyze their performance. If they have previously been involved in pump and dump scams, this could be a red flag for you to be wary of where you are investing because a crime committed once does not guarantee that the individual would not repeat it again.
8. Breakthrough claims
You should be cautious when a company claims to be an industry leader or to have achieved a groundbreaking discovery. If a company is legitimate, it does not need to promote its shares if it has made such an important discovery. It is difficult to believe that a newcomer in a particular field can claim to be an industry leader. Allow your work to speak for itself. Do not be scared by unsubstantiated assertions. Look into how long the company has been in operation. To persuade investors, it is easy to talk favorably of a fledgling company’s ability to create profitable returns in a short period of time.
9. Share Repurchase
Buybacks are frequently used to lower the quantity of shares on the market. The primary reason for a corporation to repurchase its stock is because it believes its stock is cheap. The reduction in the number of outstanding shares raises the company’s earnings per share ratio, which attracts investors. Insiders may also be attempting to demonstrate that they have made a substantial profit in order to be able to purchase back their shares. However, it could be a ruse used by insiders to boost the success of a pump and dump strategy. As a result, do not merely invest in a firm because it has made pronouncements about share buybacks.
10. Reverse Mergers
A reverse merger occurs when a private firm merges with an existing public corporation to become public. The private firm that wishes to pursue a reverse merger does not need to submit certain doplusentation that would have been required if it had offered shares to the public through an Initial Public Offering (IPO). This means that investors interested in purchasing the stocks of such a company will not be able to learn about the potential dangers, the level of assets and liabilities, and other essential factors before making a purchase choice. As a result, reverse mergers create an ideal setting for a pump and dump. As a result, investors should be wary of reverse mergers.
Finally, the most effective strategy to preserve your investment is to educate yourself on what the stock market is, how it works, and the fundamentals of investing. Purchase some excellent investment books. If you’re new to investing, stick with trustworthy firms that don’t force you to make specific investments. Most importantly, always follow business trends rather than pop culture trends. Pop culture trends may appear indisputably intriguing and may be the talk of the town; but, just because something is trendy now does not guarantee that it will be popular in the long run. As a result, instead of following the herd and relying on rumors, conduct your own study.