How does a pump and dump scam work?

By Investopedia Staff AAA
A:

A pump and dump scam is the illegal act of an investor or group of investors promoting a stock they hold and selling once the stock price has risen following the surge in interest as a result of the endorsement.

The stock is usually promoted as a "hot tip" or "the next big thing" with details of an upcoming news announcement that will "send the stock through the roof". The details of each individual pump and dump scam tend to be different but the scheme always boils down to a basic principal: shifting supply and demand. Pump and dump scams tend to only work on small and micro-cap stocks that are traded over the counter. These companies tend to be highly illiquid and can have sharp price movements when volume increases. The group behind the scam increase the demand and trading volume in the stock and this new inflow of investors leads to a sharp rise in its price. Once the price rise has formulated, the group will sell their position to make a large short-term gain.

An Example:
During the summer months of the stock below a pump and dump scheme was initiated by using a "wrong number" scam. A message was left on victims answering machines that talked of a hot stock tip and was constructed so that the victim would think that the message was an accident.

pumpanddump.gif

As seen in the above chart, the price rose from around $0.30 to nearly $1.00, a more than 200% increase, in a one-week period. This drastic increase was seen along with an equally large increase in volume. The stock had seen an average daily trading volume before the price increase of less than 250,000 but during the scam the stock traded up to nearly one million shares on a number of trading days. The unsuspecting investors would have bought into the stock at around $1.00. As seen above, it fell to around $0.20 - an 80% decline in value for those unfortunate investors.

Note to Investors
Always keep this investment caveat in mind: "If it's too good to be true, it probably is". If someone you don't know gives you a stock tip, stop and think about why they would be so willing to give you such hot information. Do not think that you can make a large and quick investment return because it's unlikely to happen. It's also vital that you do your own research about any investment. This should help you to avoid being duped by such pump and dump scams.

For further reading, see the Investment Scams tutorial and Playing The Sleuth In A Scandal Stock.

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