A pump and dump takes place when insiders of a company make false and overly promotional statements about the company in order to temporarily inflate the stock price.
The insiders then sell their shares of the stock into the buying, making a profit for themselves.
It’s called a pump and dump because the price changes (pump) are based on hype and the stock will inevitably collapse back to, or below, it’s pre-pump price (dump).
Popular movies like Boiler Room and The Wolf Of Wall Street have portrayed the Long Island brokerage firms from the 1990s that became famous for orchestrating pump and dumps, with naive affluent clients as their victims.
See the clip below from The Wolf of Wall Street where Jordan Belfort joins a small Long Island brokerage firm and sells shares of a “high-technology” firm that is actually just two brothers that are maybe making something in their garage:
Let’s briefly review the rough schema of how insiders or “pumpers” run their scheme:
To begin, pump and dumps typically occur in very illiquid, thinly traded stocks. Oftentimes these trade on the over-the-counter or “grey” markets.
OTC companies are pretty opaque. Many of them do not actively report financial statements or disclosures to the SEC, and frequently the companies are nothing more than empty shell companies created solely for the purpose of manipulating the stock price.
Before insiders begin a scheme, it’s not uncommon for just a few hundred dollars a day to be transacted in the stock.
For reference, even the smallest company listed on the New York Stock Exchange typically trades over a million dollars of stock per day.
Because of the illiquidity, just a few small transactions can dramatically alter the market price for the stock, which can lure naive investors into buying the stock, expecting further stock price growth.
Insiders will typically hire promoters that call themselves “investor relations” firms to pump up the stock price.
These firms are not to be confused with legitimate investor relations firms who help investors in a publicly traded company understand the company better and disseminate corporate information.
These stock promoters will use email blasts, text message blasts, message boards, and even direct snail mail to promote their stock picks.
The promoters amass large lists of naive investors who are interested in buying stocks they’re told could be the “next Amazon.”
The first step there is loading up on cheap shares.
Many times the insiders of this scam actually own most of the company, so that’s easy for them to do without moving the market too much. But to really get the stock to catch a bid they typically hire stock promoters who have a track record of pumping several stocks in the past.
They compensate the promoters with mostly shares of stock, giving the promoters a strong incentive to pump the stock as high as possible.
So what do the promoters do?
Well, if you’ve subscribed to a lot of stock market related newsletters, you’ll realize that many of them “rent” their email list to these stock promoters.
The promoters pay the newsletter owners a fee to send the promotional material to newsletter subscribers. A small number of them fall for it and buy the stock. Multiply this several times for several newsletters, social media posts, and whatnot, and the promoters have enough naive investors buying the stock to push the price up.
Once the price starts spiking and the volume is coming in, the insiders begin to sell their shares to the new buyers, cashing out for a fast profit.
If you watch the price action of one of these pump and dumps intraday, it looks like the insiders sell gradually, so as to not spook the buyers. Eventually, though, the amount of new buyers dries up, and early buyers are ready to cash in their profits.
This is when the insiders sense that the jig is up and rush to sell what they can at the elevated levels, creating the dump.
Many day traders specialize in identifying potential pump and dumps and wait for the momentum to start waning and establish a short position (if they can locate shares).
However this is a potentially catastrophic strategy, should the insiders decide to do another round of pumping. It’s certainly not for the faint of heart.
Example of a Real Life Pump and Dump
In Jack Schwager’s most recent addition to the Market Wizards series, Unknown Market Wizards, he talks to a penny stock trader who got caught up in a pump and dump called SpongeTech.
The company sold soap-filled sponges and licensed the rights to use popular cartoon characters like SpongeBob. The product was real, but the sales weren’t. The SEC said that they “hyped fictional customers and grossly exaggerated sales figures through dozens of bogus press releases and fraudulent SEC filings to pump up demand for stock in Spongetech”
They used their profits from their stock ownership to buy sponsorships at massive sporting events and even promoted their stock at these events.
If you zoom in on the photo, they plug their stock ticker in the bottom right of the billboard. Pretty odd, you don’t see Yahoo or Anheuser Busch doing that.
Bottom Line
Pump and dumps used to be much more prevalent back in the 1990s, during the heyday of boiler room scams.
However, they’re still alive and well. And they usually prop up around the latest fad industry.
Beware of any new OTC stocks that claim to have a growing business in the stock market’s new favorite industry.