Why Are Pump And Dump Strategies Bad? (Why Avoid Penny Stocks)

Last Updated on April 19, 2022 by Quantified Trading

Many have argued that pump and dump strategies are serving a purpose because many get rich. Isn’t it good when stock prices rise in value? What’s not to like? The problem is that the price drops when the scheme is over. We have repeatedly written on this blog that short-term trading is mainly a zero-sum game and thus leaving the last to join the pump exposed to losses.

Another small problem is that most of these pump and dump strategies are “artificial” and mostly scams, not to mention they are strictly illegal on a regulated exchange.

Pump and dump strategies are bad because they are mostly illegal but also immoral – legal or not. A pump and dump scheme benefits just a few “investors” and fraudsters. Stay away if you see a pump and dump. Don’t let the fear of missing out strike you.

What is a pump and dump scheme?

Let’s start by explaining what a pump and dump scheme is:

A pump and dump scheme is where a promoter acquires a position in a stock, normally a penny stock, and then tries to artificially increase the share price by spreading false or misleading information about the company.

Penny stocks, especially thinly traded ones, are mostly targeted because limited supply can lead to substantial price increases, often in the hundreds, even thousands, of percent. While the stock is on the rise, the promoter sells shares to the (naive) latecomers and this often causes the share price to drop significantly. It’s pretty similar to a Ponzi scheme.

The fear of missing out (FOMO) is a strong irrational common trading bias and grows stronger the more the share price goes up. This is why a pump and dump scheme can last over many days, even weeks and months.

A pump and dump example

Below is a typical example of how a pump and dump scam works:

  1. The promoter(s) accumulate shares in the consolidation phase. Pumps and dumps include mainly penny stocks, and the promoters might accrue tens of thousands of shares at low prices.
  2. After the accumulation phase starts the real “work”: the price needs to go up. How do the promoters do that? They might claim to have “insider information” that will later lift the price. It might be a new patent, a new order, etc. The point is to get a rumor spread among new investors. If many enough investors and traders believe in the coming news, increased demand lifts the share price. FOMO often gains momentum as the price goes up. This is the “pump” phase.
  3. If the promoters are successful, the price might rise substantially. Remember, a share price of 10 cents might rise to 50 cents and the promoters have a five-bagger. As the price is rising the promoters sell to the latecomers to the party.
  4. When the promoters have sold they walk away. Part 3 and 4 are the “dump” phase, and the price might return to the original price in a matter of days or weeks. There was never going to be any big news and investors and traders forget the stock and the latest to the party needs to carry the losses.

One of the famous promoters of pumps and dumps was John Lebanon, according to Wikipedia (we don’t want to disclose his name so we changed it). In 1999 he reached an out-of-court civil settlement with the SEC after being charged with stock manipulation. At the time he was only 16 years but had made almost a million dollars via many pumps and dumps.

For many months Mr. Lebanon promoted penny stocks (that he already owned) via chat rooms and message boards. Between September 1999 and February 2000, his smallest one-day gain was USD 12 000 while his biggest was USD 74 000.

As you can see, a pump and dump scam can be very profitable! If we adjust for the risk, the results are probably better (not considering the criminal offense).

In the end, justice caught up with him and he had to make a settlement with the SEC and pay back most of his gains.

In the old days, a pump and dump scheme would take place by word of mouth and faulty tips from “boiler rooms” of telephone operators. The movie The Wolf Of Wall Street is a perfect example of a boiler room where such schemes happen. In the age of Twitter, Facebook, and Reddit, word of mouth is spread digitally.

An example of how a pump and dump scheme looks like

Below is a chart in the penny stock with the ticker code JAMN listed on the pink sheets (OTC market).

The red line is the share price expressed on the right axis. The dotted blue line is the volume and is shown on the left axis. The time frame is from March 2011 until October 2011:

The volume increases during the promoters’ accumulation period but rises significantly during the pump period. The volume drops before the share price drops, and the share price drops dramatically as soon as interest fades away. In a matter of days, the share drops back to the pre-pump period.

Pumps and dumps in the crypto market

A pump and dump scheme is much more likely in the crypto market than in the stock market.

The coin and crypto market is very fragmented. You have tokens that are promising and “serious” (Altcoins) blockchain platforms and then you have the “shitcoin” market with thousands of unregulated coins. The former is unlikely to offer any chances of pumps and dumps, while the latter is very susceptible to such schemes, unfortunately. Many coins have risen thousands of percent before they eventually turn around and head down again.

Just like in the stock market the crypto pump and dump scam is normally well-organized. We believe many are organized via the messenger service Telegram.

The selected coins are normally those with low volume and on an exchange that is small. When the price rises, it triggers FOMO. The fear of missing out is extremely strong. As the rise in price gets mentioned on the internet, even in the media, it adds fuel to the fire. Those who started the scheme sell into the frenzy.

The temptation of easy money is strong. In a market where many coins quadruple and turn into a pile of “cash”, relatively quickly, it attracts many gold-seekers.

As long as the crypto market is unregulated, we believe pump and dump schemes will continue happening regularly.

Pump and dumps are bad because they are scams

Perhaps needless to say, pump and dump is, of course, strictly illegal, except in the unregulated crypto market.

We recommend staying away from such schemes and scams and don’t let the temptation of easy money make you a criminal. Don’t even think about it.

Besides, this is not easy money! You are much more likely to end up being the prey and lose your capital. Please read our previous article called can you get rich trading penny stocks?

How do you know if it’s a pump and dump?

Almost all pumps and dumps happen in the OTC market. Among the OTC market, the most usual suspects are penny stocks. It is, of course, impossible to tell beforehand if you are being fooled, but by trading in the OTC market you are exposing yourself to this risk.

Please be very careful if you invest in stocks in the OTC market.

How common are pumps and dumps?

Pumps and dumps are in practice eradicated from the major exchanges. The SEC has worked hard to go after those who initiate such schemes. Besides, most stocks on a regulated exchange are too big to get highjacked for a pump and dump scam. Thus, a stock on a regulated exchange is much less likely to such a scheme.

Pump and dump is almost entirely occurring in the OTC and the crypto market.

In a study called Who Falls Prey To The Wolf Of Wall Street? four students went through customer accounts in a major German bank from 2002 to 2015 with the help of the German supervisory authority, BaFi. This is the conclusion from the report:

Our evidence shows that investing in pump-and-dump schemes is fairly common. We find
6,569 individuals making over 20,000 purchases during the first 60 daysof the 421 pump-and-
dump schemes in our sample.Thus, nearly 6% of the investors in our sampleinvest in at least
one pump-and-dump scheme. Moreover, in any given year,there is a 2% chance that asample
investor would take a position in at least onetout campaign…..As would be expected, tout investments on average produce considerable losses with the average return to a pump-and-dump scheme being -28%.…….we estimate that the average tout generates losses for German online investors of at least €1.2 million.

According to Wikipedia, pump and dump schemes account for 15% of spam e-mail messages.

Why are pumps and dumps bad? – conclusions

Pump and dump strategies are bad for a number of reasons:

We would say a pump and dump scheme is immoral and not a legitimate way to make money – not to mention it’s very illegal in the stock market.

Also, keep in mind that you are most likely to lose money if you fall prey to such a scheme. Don’t let the fear of missing out strike you! Evidence points to losses for the majority of investors.

If you suspect a pump and dumps scheme, stay away. Instead, decide if you want to be trading or investing. If you opt for trading, then go ahead and learn how how to be systematic. We believe backtesting works and is the best way to approach trading. Don’t trade from your hip.

Think long-term!

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