Avoiding the “Pump and Dump” Scam
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.
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Tags: penny stocks, pump and dump, scam, stock scam