Pump-And-Dump Scheme: What Is It And How To Avoid It?
Table of Contents
- By Bryan Lee
- Published: Sep 25, 2023
- Last Updated: Oct 06, 2023
There are a few universal methods by which we fantasize about getting rich. We could win the lottery or inherit a fortune from a long-lost relative. Or, most realistically, strike it big in the investment scene.
However, there's a reason why many people believe investing is more trouble than it's worth. Movies and other media drill it into our heads that there's no room for compassion or ethics on Wall Street.
Unfortunately, there's more than a bit of truth to these social warnings, and scammers have an entire arsenal of cons to throw at unprepared buyers. One of these scams is the "pump-and-dump" scheme, in which groups of traders artificially inflate the value of a stock and trick other investors into buying.
What is a Pump and Dump Scheme?
Some people consider the pump-and-dump a legitimate investing strategy, but most call it a scam. The perpetrators spread misinformation, creating a "frenzy" and enticing large groups into buying their target stock. According to the US Securities and Exchange Commission (SEC), the rumors are typically propagated through social media, investment sites, newsletters, and online advertisements.
This sudden increase in interest naturally raises the value of the stock; of course, this rise is only temporary. When investors believe that stock has reached its peak, they'll immediately sell all their options, earn significant profits, and leave the victims with low-value stock.
Pump and Dump Bots
The cornerstone of a successful pump and dump is speed. Once the scammers get the stock to its predicted peak, they must immediately withdraw their investments to maximize profits. There's a limit to how quickly a human can do this.
Today, scammers use robots to fill this role instead. A bot can monitor a stock's value continuously and close multiple positions at once.
Cryptocurrencies
Digital assets, particularly Bitcoin, ignited a global investing craze a few years ago. Multiple cryptocurrency management apps shot to the top of app stores, and most people had at least a few bucks put in.
Many cryptocurrencies have an ambiguous regulatory status, making them a prime target for pump-and-dump schemes. Additionally, because traders utilize bots, crypto scammers don't need to rely as heavily on social engineering tricks to inflate the price of a coin. They just need to spark the initial interest and trick the bots instead.
Examples of Pump and Dump Scams
This scam has circulated for decades across multiple investment sectors, and it's only gotten easier to pull off with the growth of social media. A few of the biggest pump and dumps include:
The Radio Pool
The 1920s scam run around Radio Corp. of America is a testament to pump and dump's longevity. An investment group called the "Radio Pool" wound up inflating the company's share price by 500 percent between 1928 and 1929.
The members of Radio Pool continuously traded the shares between themselves to increase the perceived level of activity. Thousands of people bought into the hype and were left ruined once the shares plummeted to $10, a tenth of their original price.
Modern Twitter Machine
X, formerly known as Twitter, is the platform for sending millions of people short, unsubstantiated messages. In other words, it's the perfect medium for a pump-and-dump scheme.
In 2022, the SEC charged eight influencers for promoting stocks to their audiences before selling those same stocks. The influencers showcased their extravagant lifestyles as proof of their legitimacy as traders and created large followings of inexperienced investors. They're faced with a maximum sentence of 25 years in prison for these charges if convicted.
Centennial Technologies Scandal
Sometimes, it's not an outside group performing the pump. There's a clear motive for companies to increase the value of their stock artificially, but not many are as brazen as Centennial Technologies was in the late 90s.
The company fraudulently recognized an extra $2 million in sales for its Centennial Flash cards. Management told employees to send fruit baskets to customers and falsify sales receipts to create false evidence. This charade pushed Centennial's share price to over $50 in 1996.
Everything came crashing down when internal issues became public. The CEO was fired, and the stock lost over half its value. A later investigation revealed that, rather than making millions, the company had actually lost over $28 million in the years this scam was running.
Are Pump and Dumps Scams Illegal?
In short, yes, these scams are illegal, but it's more complicated than that. Sometimes, it's easy to prove that investment groups are in cahoots like with the Radio Pool, but often it's not.
The stock market's volatility leaves a lot of wriggle room for scammers. After all, it's not illegal for investors to recognize a high stock price and choose to pull out. It's also challenging to prove that the scammers intentionally and knowingly spread false information.
Another problem is that with global trading, like in cryptocurrencies, the perpetrators operate from different countries across the globe. This makes it extremely difficult to prosecute or even identify the guilty individuals.
How to Avoid Pump and Dump Scams
Once you understand how a pump and dump scheme works, keep it in mind when conducting your research. In general, you should always do your own research into a stock, even if it's a close friend advising you to invest. You never know if they've been tricked and you're falling into a pyramid scheme.
Does it Make Sense?
Investment seems like it'd run on pure numbers, but a good deal of emotion is thrown into the mix for most people. Pump-and-dump schemes take advantage of the excitement of speculation to trick people, and the stock in question is often ambiguous.
Most of the positive things you will hear about a pump and dump come without solid evidence. Try to find the reason why the price is soaring, and if you can't, you're probably looking at a pump and dump.
Check the Source
Imagine hearing about a killer stock and watching its price tick up each minute. It'll feel like there's absolutely no time to do your research before you miss out. This sense of urgency is what pump-and-dump scammers want from you. They hope you won't check who's behind a social media account or who sent that newsletter. Be suspicious of the hype.
Keep Yourself Safe from Scams and Schemes
Remember that it's not usually chocolate you find on your lawn. If something seems too good to be true, it probably is. Pump and dump schemes are especially dangerous for new investors since they're unsure who to trust online. Thousands of shady social media influencers and gurus fake their success or mislead their audiences.
Cryptocurrencies also offer new dangers when investing. Their completely digital nature opens the door for algorithm-based bots that are easily manipulated by sudden spikes in value. This can cause a “band wagoning” effect that tricks even more people into joining in.
So, when someone comes to you with a fantastic investment opportunity, question their motives. If you have to buy in, at least do so in small amounts until you do proper research. Check out our other posts if you want to learn more about staying safe online and protecting your finances and identity from scammers!
