Beware Of The Pump-and-Dump

The pump and dump is a classic scam that usually shows up in bull markets. The scam works best with small-cap or (even better) microcap stocks in other words, small companies that have relatively few shares or small capitalization. Scams are at their most effective when they can play on the two most overworked emotions in the financial markets: greed and fear. In the pumpand dump, greed is the operative emotion. In this example, the investor to be plucked is called Walter Pidjun (no relation to the actor Walter Pidgeon).

The insiders at the dubious company first try to promote the stock as a “hot investment.” The company activates the “pump” when insiders and/or a stockbroker, in cahoots with the insiders, call up investors such as Mr. Pidjun to tout this fantastic opportunity. They promise an opportunity to get into a profitable stock that will skyrocket in value. As a result of the high-pressure sales tactics, investors start buying the stock. This demand pushes up the price easily because so few shares are available on this thinly-traded stock.

Perhaps Mr. Pidjun didn’t bite the first time the broker called, but the broker calls again.“Hello again, Mr. Pidjun! This is Barry Kuda, account representative from the brokerage firm of Fleece, Peeples, & Scram. Do you remember that stock investment I brought to your attention last week? That’s right Titanic Bio-Tech, Inc. Have you seen the way its price has zoomed since then? When I last spoke to you, it was at $3 a share. Now it’s already at $47! Our respected research department tells me it should be at $93 by lunchtime and will probably triple again before the weekend. You don’t want to miss this opportunity of a lifetime! Now how many shares would you like?” Indeed, the price certainly went up dramatically as Mr. Kuda said it would.

Mr. Pidjun puts the order in immediately while dollar signs dance in his head. The “pump” is working very well. After the fraudulent operators see that the stock has gone as high as possible, they immediately sell their stock at grossly inflated prices. The “dump” is complete, and they disappear into the woodwork. Mr. Pidjun and the other investors watch as their “hot” investment turns stone cold and the stock plummets to pennies on the dollar. Investors were so blinded by their greed that the pump-and-dump scam has successfully been done even in cases when no stock existed at all.

Actually, isn’t this is a warning? Yes, but sometimes you need a warning for things that aren’t immediately apparent. As odd as this sounds, I want to warn you about something that technically isn’t fraud. What is it? Well, a legal version of the pump-and-dump scheme does exist. It’s not unusual for brokers and analysts to “pump” up a stock in the media. For example, a celebrated market strategist or high-profile CEO may talk up the wonderful potential of XYZ stock on a financial show. Then later you find out (through SEC filings, for instance) that while these people were recommending that people buy the stock, they had actually been furtively selling their holdings in the stock! You were hearing “buy, buy,” yet they were really saying “bye-bye.”