What is pump and dump scheme?
Pump & Dump scheme is a manipulative scheme that attempts to boost the price of a stock or security through fake recommendations. It is a securities fraud in which the price of an owned stock is inflated through false and misleading positive statements in order to sell cheaply purchased stock at a higher price.
First the operators of the scheme will promote the shares through social media platforms, emails, newsletters, posting in groups, bulk messaging etc and create a hype. When investors fall for their trap they will sell “dump” their shares at a higher price thus offloading the same to the investors who enter the market at a higher price leaving them holding worthless securities and losing their money.
Nowadays this is most common with small cap crypto currencies and very small (microcap) companies.
Have you wondered why this scheme occurs?
The main intention of the fraudulent investors is to make quick profits at the expense of other investors. The stock is generally promoted as a hot tip stating that the upcoming events will push the share price of that company much higher. This creates demand leading to rising of the share price dramatically. When the prices are at record high operators will sell their shares.
Lets take an example
AB Company is a new company with a market cap of Rs.20 Crores and its shares are trading at Rs. 2. Investors engaged in pump and dump scheme would purchase large quantities of shares and would then start promoting the same to normal investors.
Since these shares are cheap, prices can dramatically increase when demand picks up. Due to sudden increase in the demand normal Investors will be inclined to purchase and will end up purchasing the stock at an inflated price lets say Rs.4. Operators will sell the shares at this point and earn 100% return. In the coming days share price will again tumble to its original price i.e. Rs. 2 due to heavy sell off. Now Genuine Investors who are still holding the shares are at a loss.
Did you know?
On 10 June 2015, Surana Solar shares jumped 18% after it was reported that ‘Rakesh Jhunjhunwala’ purchased 250,000 odd shares & then it crashed to its lower circuit next day, as the identity of the investor was revealed. As soon as the news was made public, there was frenzy amongst the punters to grab the stock. This sent the stock price surging to an all-time high of Rs. 63. At this stage, the operator dumped his holding of the stock, leading to abnormally high volumes on the exchanges. Later, when news leaked that the “Rakesh Jhunjhunwala” who had bought the stock in the first place is not the ace investor ‘Rakesh Jhunjhunwala’ but a namesake, the stock price plunged to a low of Rs. 32.
The Wolf of Wall Street’s Jordan Belfort swindled investors out of millions of dollars in the early 90’s using Pump and Dump scheme at his stock brokerage firm Stratton Oakmont. After being found guilty of securities fraud and money laundering, Belfort was imprisoned for 22 months and was forced to pay back $110 million to the investors he deceived.
Now Lets discuss on how to avoid pump and dump scheme:
Be careful when you get flooded with information from unknown sources
Don’t rely on every email, message you get from an unknown source. Especially when the information focuses only on positive sides and not on risks as some of them will be paid promoters to convince you that the suggested stock has an upside potential. But don’t fall for it.
Check company’s age
Often in pump and dump operators will convince investors to buy new company’s shares projecting the company’s ability to prosper in future.
But before getting inclined towards investing in a stock based on unsolicited information received check company’s age and its business thoroughly. Only if you are convinced about the company go for it.
Know the in charge of the company
Check if the business is well managed. Know if the management is competent to run the company. Understand the relevant information regarding the people behind the company. Are they involved in scandals? These are questions to be answered before being the victim of someone else’s pump and dump scandal
Avoid investing in penny stocks
Penny stocks are those which trade at a very low price and have low market capitalisation and are generally illiquid. Due to limited information available Penny stocks are more prone to pump and dump scams hence one should avoid investing in penny stocks.
Due to the internet, In recent years this illegal practice has become a common thing.
Investment advice such as stock tips may be convenient, but it is important to remember that are still plenty of wolves on waiting to pounce on you. So, always perform your own research on recommended stocks in order to avoid pump-and-dump schemes and other get-rich-quick scams
Thanks for reading!
Author: CA Krishna Bhanushali
Email Id: email@example.com