If you spend much time reading financial information online, you’ve probably noticed that many otherwise reputable sites have sidebars displaying advertisements touting penny stocks, with a come on like ‘3 penny stocks about to soar.’ In fact, you probably see several of them on my sidebar, now that I’ve used the phrase ‘penny stocks’ in this article. The problem with penny stocks is that, by definition, they are associated with lightly traded companies who have only a small net capitalization, making them subject to any number of scams. Which brings us to today’s topic…
The basic pump and dump scam has three main parts. First, the schemers buy up a great deal of a stock, preferably one with a small price, allowing them to purchase a lot of shares. Second, the schemers attempt to build a buzz for the stock, touting it on message boards and other resources, hoping to pump up the perceived value (the ‘pump’ part of the scheme). This is why penny stocks and others with few outstanding shares are favored; few scammers possess the resources needed to move the price of large-cap stocks, given the high trade volumes, large numbers of shares and many sources of other information.
Finally, after the price of the stock has risen significantly, the scammers sell their shares, netting a large profit and leaving the victims holding greatly overpriced shares (the ‘dump’ step of the scheme). The overall result is schemers who profit greatly, and investors who lose money on stocks they never should have purchased.
A Historic Pump and Dump Scheme
Jonathon Lebed: An example of one teenager doing something other than loitering, he made a small fortune buying penny stocks, touting them on message boards, and then selling them. The SEC caught wind of him and prosecuted him (the first time they ever prosecuted a minor), eventually settling out of court and allowing Johnathon to keep more than a half a million dollars in profit. Not bad for someone who couldn’t legally drive at the time.
An Example Pump and Dump Scheme
Once again, I decide I can make a much higher profit by running a stock scheme than I can by blogging, and this time (luckily for our example) I decide to try a pump and dump scheme. I search through the ranks of penny stocks, eventually settling on one (or a small number) that are selling for a very small price, are lightly traded, and sound vaguely intriguing. I purchase a large number of shares of each company, after I do some homework to ensure there isn’t much information to be found on any of them.
After I buy up a large amount of these stocks, it’s time to make them appealing to other investors. There are any number of ways to do this; creating a fake review of the company, making a video that calls it the ‘pick of the century’ or even writing posts recommending my own stocks on a financial blog. To ensure that people encounter my ‘pumps’, all I need is some clever and provocative ads, like the ones mentioned at the start of this article, placed on sites that gather a lot of traffic. Before long, I’ve got thousands of people reading my ‘expert’ views on these crummy stocks, and with few, if any, sources contradicting me, more than a few of them will take me at my word and start bidding up the stock price in their rush to buy.
Depending on how greedy I am (as well as how much I think my touts will bump up the price of the stock before people get wise to my scheme), I can start selling after the stock prices double, or triple, or increase ten-fold, netting me massive profits. I will more than cover the expense of the advertising and other costs associated with setting up the scheme, leaving the people I conned into buying those securities holding the bag, with stocks that have no justifiable reason for their high valuation.
How to Protect Yourself
Avoid Penny Stocks – Frankly, there’s few reasons to ever consider penny stocks. There are plenty of opportunities in small cap stocks that are small enough to grow rapidly, but large enough that they can’t be readily manipulated by unscrupulous profiteers. Save yourself a great deal of time and aggravation and avoid penny stocks (and other questionable investments, while we’re on the subject).
Be Skeptical About Investment Advice – Hopefully, you already take most investment claims and suggestions with a grain of salt; not all advice is appropriate for everyone, after all. But especially when taking advice from online sources (which do not require fact-checking or even knowledge of the creator’s true identity), you have to stop and ask yourself what the writer has to gain from you following their advice. Most people, if they have a stock they genuinely believe will increase many times its current price in a short time, will not be willing to share that stock’s identity with you; if they are, you have to ask yourself, why?
Do Your Own Research – Alright, so you’ve just read about a stock that sounds like a fantastic investment. Before you go and buy based on a single recommendation, it’s time to do plenty of research. There should be plenty of resources that detail the stock, providing you with material to support your choice, or perhaps to change it. If you can’t find research on the stock (preferably from large, well-established firms and not just blogs or other ‘anonymous’ sources), then do yourself a favor and don’t buy it.
Follow these simple steps, and you should have few problems with ‘advisers’ trying to pump up their stocks and then dump them on you.