What is Pump and Dump?
A pump and dump scheme is a type of securities fraud that involves the artificial inflation (“pump”) of the price of a security through false, misleading, or exaggerated statements regarding the security’s price. The fraudster can profit from the price inflation by quickly selling the securities at a high price (“dump”).
At the same time, the new owner of the shares will likely lose a substantial part of their capital because the security’s price will quickly fall. The pump and dump scheme is considered an illegal activity.
How Does the Pump and Dump Scheme Work?
The scheme often involves the manipulation of microcap stocks (penny stocks). They are the stocks of companies with a small market capitalization. The microcap stocks are usually traded over-the-counter (OTC) at an extremely low price (less than $1 or equivalent). They do not adhere to strict requirements for public listing.
Therefore, the information about the securities can be easily manipulated by the fraudsters. The lack of public information creates additional favorable conditions for fraudsters as potential investors lack enough sources to check all available information about a company.
In addition, microcap stocks are highly illiquid securities with extremely low trading volume. Thus, even relatively small transactions can significantly inflate the price of the security.
In a pump and dump scheme, fraudsters may use various tools, including cold calling, email spam, and fake news releases.
Types of Pump and Dump Schemes
There are several types of pump and dump schemes that may be utilized by fraudsters. They include the following:
1. Classic pump and dump scheme
The classic scheme may involve any type of manipulation of information regarding a company and its stock. It may include stock pitches via telephone, fake news releases, and distribution of some sort of “inside” information that can boost the stock price. In addition, the services of dishonest stock promoters can be used to attract the attention of investors to the stocks.
2. Boiler room
A boiler room is a small brokerage firm that employs a number of brokers that use dishonest sales practices to sell questionable investments to investors. The brokers sell penny stocks that the firm buys or sells as a market maker by employing cold calling. The brokers working at boiler rooms try to sell as many stocks as possible, thus boosting the price of the stocks. Once the stock price rises, the firm sells its shares of the stock for a profit.
3. “Wrong number” scheme
The “wrong number” method is a new pump and dump scheme. Some people may receive voicemails from strangers with a “hot” investment tip to a friend. The fraudsters want you to believe that the voicemail was accidentally left on your phone. However, it is a targeted action to attract the attention of potential investors to a particular stock and boost the demand for this stock.
CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: