Risks of Pump and Dump Strategies: The Case Against Penny Stocks
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 strategy?
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.
Example of a pump and dump strategy
Below is a typical example of how a pump and dump scam works:
- 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.
- 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.
- 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.
- 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 big