Have you heard about pump and dump scheme? Possibly yes! But if I may ask you, what do you understand by pump and dump stocks? If you are an avid investor, you might probably know the meaning. But there are many beginner investors here who may want to understand its meaning. Therefore, before I go to the thrust of the article which is “how not to fall victim of pump and dump scheme” it is important that you understand the term. The reason is simple. If you are running on a road and you don’t know that there is a pit ahead, you might likely fall into it. But if you are aware of pot holes ahead of you while driving, you will know how to drive carefully. But that may not be enough to guaranty that you will not fall into the pothole. Imagine you are driving at night without your head lamp on, I can assure you that you may suddenly realise that the tyre of your car has been hooked in a hole or you discover that the tyre has been punctured.
This is exactly what is happing in the investing world. Some are unaware that there is something called pump and dump scheme. This set of people is likely to fall victim of the scheme. Another class of people are individuals who are aware of the scheme but don’t have adequate insight about it. This also makes them vulnerable too. So as I said, I will assume that everyone is on the same page. That is, I assume that you know little or nothing about the scheme. Therefore, let me explain how it works.
What is pump and dump scheme?
Pump and dump scheme is used to describe a situation where an investor or a set of investors makes a hype around a particular stock in which they have interest. They do this with the intention of creating false impression about the stock in order to drive up its price. The hype makes unsuspecting investors to believe that the stock is a hot pick. They will start scrabbling for the stock. With much demands, the stock price will begin to rise. As soon as the price of the stock gets to an appreciable level, the person or people that created the hype quickly offload their stocks thereby making them to catch out huge profits. Immediately they sell their stocks, they stop the hype and the price of the will suddenly plummet. This may result to a heavy loss to those investors that bought the stock when the price has capped. Of course, this act is illegal and the Securities and Exchange Commission (SEC) frowns at it. If the culprits are later found out, they may be made to pay for this. They may even be suspended from training penny stocks. But what happens to those people who have lost their money? Well, they may need to leak their own wounds.
Why do people buy pump and dump stocks?
You may want to know why people would buy into such stocks. Well, some of them do it ignorantly. They don’t know that it is a pump and dump stock. Initially, pump and dump stocks will look as hot picks. It is at the end of everything that some of the unsuspecting investors will realise that somebody somewhere has played them. The schemers use many tactics to recruit investors. They use radio jingles or paid sponsorship. They may send mass mails to people claiming that they have insider’s information about the company about a particular project that will enhance the value of the company. Of course, they will not disclose their motive. All what they do is to create false news about occurrence of events which will make the price of the stock to go up. They may even create a sense of urgency around it saying, that if you don’t buy the stock now, you might miss the opportunity. Because the mail is a spam, thousands of people will receive the same information. Before you know it, people will begin to respond by buying the stock and the price of the stock will start to rise. By the time other people that may be sceptical about the news initially begin to see the stock price rising, they may likely jump in to seize the “opportunity” too. The bandwagons continue to force the price up and the schemers will be watching until the stock price has reached a satisfactory level and then catch in their gains. Before, it used to be just jingles but with the proliferation of the internet, they can post their releases in chat rooms and bulletin board postings.
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How to identify pump and dump stocks
One thing that is common to all pump and dump stocks is “hype”. If you are getting hypes about a particular stock, especially the kind of hypes that you cannot substantiate, you need to tread carefully. Another characteristic of pump and dump stocks is that, they are mostly penny stocks which are low-priced and people don’t trade them regularly. They are traded over the counter (OTC) and Pink Sheets exchanges. Some penny stocks companies are not regulated by the Securities and Exchange Commission (SEC). Some of them don’t even meet the listing requirements. So, the investor communication obligations are not there thereby making it difficult for investors to actually find concrete information about the stocks. Scammers are aware of this. That is why people usually refer penny stocks as pump and dump stocks.
How to avoid pump and dump stocks
- Watch out for hard marketing: Investment is a good thing but you should watch out for high pressure pitches from brokers. If any broker comes to you and continue to pressurise you not just on the need for you to invest but to invest in a particular stock, you may need to be careful. Apart from the fact that some brokers are on commission, they make more gains if they are successful at luring people into buying their so called “hot stocks”. If a broker pressurises you to buy a stock promising you quick returns, don’t be carried away. If you want to know whether he is just after his commission or because he is having a special interest in the stock that he is pitching to you, you can offer to buy another stock through him. If he insists that you just have to buy his own stock pick, there may be something filching.
- Master your emotion: You need to be able to demonstrate emotional maturity when it comes to stocks investing. If you are greedy, you can easily prey of “get rich quick’ offers. If someone is promising you dramatic financial turnaround within a month, he may be playing on your emotion. In most cases, it is the greedy people that fall victims of scammers. That is, those people that are looking for easy routes to success. A campaign saying that if you invest just $1,000 in a stock, you will become a millionaire within six months is just an example of pump and dump scams. The offer is attractive of course but it sounds too good for me to believe. If any investment offer looks too good, it can really be a scam. Allow your sense to guide you and never allow your emotion to rule you.
- Be a value investor: Value investing is not just about buying low-priced stocks. It means buying stocks at a price that is less than the amount they are actually worth. This is where some beginner investors miss it. They think that if they buy a penny stock, its price will definitely rise. This is a myth. A low priced stock does not mean a cheap stock. A low priced stock can be very expensive. You cannot prove that a stock is cheap if you don’t know its worth. It is when you know the value of a stock that you can say that the stock is undervalued. Rely more on the results of your fundamental analysis rather than the hypes that the price of a stock will rise. In most cases, you may not find anything to justify any future rise in the price of the pump and dump stocks except just hypes.
- Don’t subscribe to untrusted newsletters and emails alerts: If you surf through the internet, you will find a lot of stock recommendations. Unfortunately, not all the websites that offer stocks recommendations are genuine. If anyone is recommending a stock without having a good research team made up of professionals, I will suggest that you should not subscribe to their newsletters. If you subscribe, you may discover that they will soon begin to flood your inbox with pitches to buy certain hot stocks. If their messages come to you when you have some idle funds, you may not be able to resist the offers.
- Get information from right source: There are actually some hot stocks out there but you need to ensure that you are getting your information from the right source. There are some trusted websites such as Bloomberg, Google Finance, Yahoo! Finance and S. Securities and Exchange Commission’s Electronic Data Gathering, Analysis and Retrieval (EDGAR). You can search through EDGAR to find out if investment is registered at all. If it is a small company, it is possible that it may not register with Security and Exchange Commission (SEC). Nevertheless, you should endeavour to check from your State and Provincial Regulator. Good sources of information are prospectus and the financial statements of a company.
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It could be very painful to fall victim of pump and dump scammers. But the truth is that if you do your due diligence, pump and dump stocks are easy to recognise. You just need to ‘shine your eye’.