There’s a new company about to launch, and investors are clamoring for a piece of it. It’s starting at just $1.00 a share, but in just a month, it could be worth up to $20.00 a share. But you’ll have to act fast, since so many people are excited to be a part of it.
Have you heard a story like this before? If so, there’s a good chance it was a “pump and dump” scheme, designed to make fast money off unsuspecting investors. So how exactly is this scheme supposed to work, and how can you spot one safely?
How a Pump and Dump Works
The idea behind a pump and dump is simple. Some new type of asset—such as a company making an IPO—is heavily promoted to new investors, in an attempt to build hype. Typically, the promoter has a sizable stake in the asset already. As more investors start investing in the asset, the price goes up. In extreme cases, the price can multiply many times over. As the price increases, more unsuspecting investors buy into the hype and add to their positions in the asset. This is the “pump” portion of the scheme.
At this point, the promoter sells off their position, reaping a sizable profit—the “dump.” At some point in the future, usually days or weeks from the initial rise, investors start realizing the company or asset isn’t really worth anything; they start selling in a panic, and the price plummets to its original price, or even lower. The scheme can be used for almost any type of asset, and has recently been used for newly launched cryptocurrencies, since the market is so volatile and exciting for new investors.
How to Spot a Pump and Dump
So how can you spot a pump and dump?
These are the hallmarks to look for:
- The history of the asset. How long has the asset been around? If it’s about to launch, or if it’s only been around for a few weeks, count it as a strike. It’s definitely possible to invest in a strong asset that’s relatively young, but without an extended price history to gauge your decision, it’s hard—if not impossible—to invest with confidence.
- The price of the asset. Though not always the case, most pump and dump strategies are limited to assets with a low per-share value, including penny stocks and offers of a similar tier. Again, a low price shouldn’t be enough by itself to scare you away, but it’s another strike to consider if you’re trying to fairly evaluate the opportunity.
- The reliability of the promoter. Who’s behind this promotion? What has their posting history been like? Typically, you’ll see pump and dump schemes being promoted by new accounts—fake authors and users that have been created specifically for this purpose—or by accounts that have promoted other pump and dumps in the past. Investigate your sources, and see if you can find any neutral third parties that can back up what they’re saying.
- Recent trading history. What kind of trading volume has this asset seen in the past few weeks? If there’s a massive spike in trading volume or price volatility, it’s a sign of overinflated hype and interest. You’ll want to prioritize assets with greater stability if you’re trying to avoid pump and dumps.
- The amount of current promotion. How much is this asset being promoted? If you see multiple posts and articles calling for investment in this asset, and they all look similar in terms of tone and argumentation, it’s a sign that someone is heavily interested in driving up purchases for this asset.
- The type and place of promotion. Also consider the location where you saw the promotion; was this a recommendation from a trusted advisor in person, or a random post from a user on your favorite investment forum? Was this well-articulated, with financial details, or did you walk away still uncertain about what the company does? You’ll also want to pay attention to subtle quality indicators, such as what sources are cited in the recommendation, and how well-worded the recommendation is.
When in Doubt…
As a general rule, you should only invest in assets that you truly understand. While it pays to take risks, learn new things, and venture into unfamiliar territory, it’s unwise to put much stake in anything that you haven’t first researched and attempted to understand in some detail. Accordingly, if you’re even slightly suspicious that the asset you see is being promoted as a pump and dump strategy, or if you aren’t sure what you’re getting into, you’re better off waiting for an opportunity you understand better.