Retail investors often fall prey to a particular type of scam, involving penny stocks, that is prevalent in the stock markets.
The Pump and Dump Scam – as it is popularly called; involves a group of operators fraudulently increasing (pumping up) the price of a stock they hold, by spreading market rumours and then selling these stocks (dumping) to unsuspecting investors at a higher price.
The Pump and Dump Scam:
Typically, the pump and dump scam operates in the following manner:
- A group of investors with somewhat deep pockets, target low priced (penny) stocks of non-operational or loss-making companies with low trading volumes. This is because it is easier to manipulate the price of stocks with low volumes as compared to the stock of an established company with significantly higher trading volumes. Volume is the number of shares of a particular company which is traded (exchange hands) on any given day.
2. The operators then start buying shares of this ‘target’ company in large quantities.
3. We know that stock prices are an interaction of the forces of demand and supply. Since the operators deliberately target stocks with lower trading volumes, an increase in demand of the stocks on account of the large scale buying by the operators – leads to a significant increase in price of the stocks.
4. The operators then start propagating positive rumours about the company. For example, this could be the news of winning of a significant contact, by the company, in a remote country that could potentially increase the revenues and profits of the company manifold. The rumours are propagated through various communication channels like social media, emails, text and calls. Social media makes the jobs of these scamsters a lot easier.
5. The recent increase in the price of the stock of the ‘target’ company – brought about by the buying actions of these colluding operators – lead some of the unsuspecting investors to believe that the so called market ‘news’ about the company might actually be true.
6. In anticipation of making some quick profits, these investors flock to the markets to pick up the stock in large quantities. This creates further demand for the stock in the market and its price skyrockets. The operators then offload their holdings to these unsuspecting investors at these inflated levels – walking away with large profits.
The Lessons to be learnt:
Such stock market scams can teach investors some valuable lessons.
For starters, never act on a particular news before verifying its source from multiple credible sources.
Also, never make an investment decision based on someone else’s recommendation. Do your own research, try to find out the basis of such recommendation, verify the facts from multiple sources and ask yourself whether something is too good to be true. Remember to always formulate your investment decisions based on facts.
You can read our article on what makes a company a good investment fit to know more about the type of companies you should look to invest in.
Thanks for your time. Happy Investing!
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