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Pump and Dump

The artificial inflation of a security's price and profiting from the price rise

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.

 

Pump and Dump

 

How Does the Pump and Dump Scheme Work?

The scheme usually 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 lower 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 small transactions can significantly inflate the price of the security.

In a pump and dump scheme, fraudsters may use various tools, including the cold calling, email spam, and fake news releases.

 

Types of Pump and Dump Schemes

There are several types of the 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 release, 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 and thus boosting the price of the stocks.

 

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 to pursue 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.

 

Additional Resources

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:

  • Insider Trading
  • Market Capitalization
  • Momentum Investing
  • Trading Mechanisms

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