There are many ways that the scammers try to part traders from their trading capital.  One way is the “pump and dump” scam, which is used on low priced stocks, which are also known as penny stocks.  Technology and the Internet have created some new variants of this scam, which stock traders need to be aware of.  This article helps you identify a pump and dump scam and understand how they work so that you can avoid becoming another victim.

How Does Pump and Dump Work?

As the name implies, this scam has two parts.  Firstly a low priced, small capitalisation stock (also known as a penny stock) is pumped up.  The scammer encourages a lot of people to place purchase orders.  This has the effect of moving the price significantly upwards.

The pump will only work with obscure, low priced stocks.  Why is this?  Well, if 1,000 small traders bought shares in GE, would it move the price much?  No.  That trading is a drop in the ocean.  But if the daily trading volume of a stock is only 2,000 shares, and 1,000 traders buy 500 shares each, that will substantially move the price.  The issue is liquidity - small increases in volume will move the price around for small stocks.

The next part is the dump.  The scammer sells all their holdings at the increased price, and takes advantage of the fact that victims are already buying, which creates liquidity, or a market for the scammer’s shares.  The victims are left holding the bag.  When it comes time for them to sell, a lot of shares will be dumped onto the market without anyone to buy them.  Liquidity dries up as soon as buyers leave the market.  Some may be lucky enough get out at a profit, but most will suffer a loss.

Win or lose, trading to move a market is also illegal trading activity.  Besides losing money, anyone who trades this way may end up in prison.

Characteristics of this Scam

The first characteristic is that this scam uses penny stocks, or low priced, low capitalisation stocks with low trading volume. As mentioned, it won’t work on S&P 500 stocks because it takes a lot of buying to move these, and they offer strong liquidity.

The second characteristic is that the trade recommendations are usually made on Monday or Tuesday. This allows the scammer to purchase an initial position on Friday before releasing the buy recommendation.

The third characteristic is that the trading advice is presented as very short term, with a holding period of one or two days.

The fourth characteristic is that the trading advice offers some sort of unique insight, for example advice from a special computer program.

How is this Scam Perpetuated?

There are three ways that modern scammers carry out this scam using modern technology.

The first way is by spamming thousands of people with “stock tips”. The hope is that enough people will buy the stocks, forcing up the price.

The second way (closely related to the first way) is by posting to online trading forums. A lot of people lurk on these forums, looking for advice from other people. The scammer posts a convincing statement that a stock is about to increase rapidly in price, and waits for other people to follow the lead.

The third way is the most clever of them all. I am amazed by the ingenuity of it. The scammer says that they have a special computer program that can pick penny stocks that are about to increase in value. They send out a paid newsletter with the buys for people to follow. After a while, they offer a copy of the program for sale, which simply remotely queries a database for the stocks that have already been selected for pumping - there is no actual stock picking logic.

So in addition to getting money from the newsletter and sale of the program, they also get the profits from pumping selected stocks.

This particular scam states that the program was developed by an ex Goldman Sachs trader. Of course, this is a lie. Goldman Sachs is not about to trade penny stocks.

The advertisement shows a picture of a candlestick chart and states that it looks like something that NASA would make. The target audience is obviously those who are unfamiliar with trading.

If you had a program that could accurately pick stocks, would you sell the results for $47, or the program for $97? I have some software that picks changes in trends, and I am not selling it for any price. Also, the program for sale is a black box - you should always be very careful of trading with any program that doesn’t have disclosed logic.

Conclusion

The pump and dump scam not only loses you money, but is also illegal. There are no short cuts to stock trading profits, no special newsletters or black box computer programs that will help you suddenly acquire riches.

The antidote to being scammed is knowledge of the market, and you can gain this by reading widely and educating yourself, rather than putting your trust in untrustworthy scammers who make their money, not through market mastery but by ripping off others.

Tags: penny stocks, pump and dump, scam, stock scam

This entry was posted on Sunday, October 12th, 2008 at 5:16 am and is filed under Scams to Avoid. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.