By Parthajit Kayal and Malvika Saraf
Pump-and-dump scheme is a form of scam that encourages amateur investors to buy shares in a company to increase the price of the shares artificially. It can be used to boost the price of a stock through recommendations based on false or misleading information. Pump-and-dump traders use social media platforms or messaging apps to start rumours, spread misinformation, or hype to fan interest in the stock to increase its price. Once the price of the stock rises, the fraudsters sell the stock at high prices.
What is pump-and-dump
Pump-and-dump is a type of activity that attempts to boost the price of a stock through recommendations based on false, misleading or greatly exaggerated statements. There are two parts to this method.
Pump: Fraudsters organise a well-planned campaign to inflate the market price. This campaign is generally carried through social media and online forums to disseminate false information about a listed stocks’ future prospects.
Dump: Once the price goes up, the perpetrators sell their shares. New investors then lose their money if the prices drop dramatically after the traders sell their shares.
Different ways used to manipulate investors
There are many ways this pump-and -dump method is used. First, by manipulation of information regarding a company and its stocks via telephone, fake news releases, and distribution of some ‘inside’ information that can boost the stock price. Sometimes, a small brokerage firm employs several brokers that use dishonest sales practices to sell investments to investors.
The brokers sell stocks by cold calling. They sell as many shares as possible required to boost the price. Once the stock price rises, the brokerage firm sells its share of the stock for a hefty profit. Many times, small-scale media outlets are involved in this scheme of price manipulation.
How it is used in the stock market
Pump-and-dump schemes usually target micro- and small-cap stocks or new asset classes like cryptocurrencies which are relatively illiquid and therefore easiest to manipulate. Only a few shares of this type float in the market and sold over the counter, only a few new buyers are needed to push a stock price. This new inflow of buyers causes stock prices to increase rapidly. Once the price rises, the traders sell their shares to get a sizable short-term gain. The details of each pump-and-dump scam can be different, but the scheme has the same basic principle: changing supply and demand of a stock.
The stock is usually promoted as a ‘hot tip’ or ‘the next big thing’ with details of an upcoming news announcement that will ‘send the stock through the roof’. Pump-and -dump scams tend to only work on small and micro-cap stocks that are traded over the counter. These companies tend to be highly illiquid and can have sharp price movements when volume increases.
The concerned group of individuals behind the scam increases the demand and trading volume in the stock and this new inflow of investors leads to a sharp rise in its price. Once the price rise has formulated, the group will sell their position to make a significantly large short-term gain. This causes the price to drop dramatically. New investors then lose their money.
One should always keep this investment caveat in mind: “If it’s too good to be true, it probably is.” If we get an anonymous stock tip, we should stop and think why they would be so willing to give us such information. It is unreasonable to think that one can make a large and quick investment return because it’s unlikely to happen. One’s own research about any investment is extremely vital. This should surely help investors avoid being duped by such pump-and-dump scams.
Kayal is assistant professor, Madras School of Economics and Saraf is a recent graduate, Madras School of Economics