A pump and dump scheme refers to a situation where a person or group of people buy shares in a company, promote it, and then sell them at a profit. In most cases, the shares tend to decline after the hype. In this article, we will look at some tips about how to identify pump and dump schemes in the stock market.

What are pump and dump schemes?

A good way to explain these schemes is to use an example. Early in 2020, something happened in the financial market. After years of weakness, shares of several unloved companies like GameStop and AMC Entertainment skyrocketed. 

GameStop is an old-fashioned company that sells video games in retail outlets. Its revenue has been falling for years as people turn to mobile and online games. 

AMC, on the other hand, is a company that operates movie theatres in the United States and Europe. Because of the coronavirus pandemic, the company lost business as more people stayed indoors. In fact, at some point in 2019, it was considering filing for bankruptcy. 

Within a few trading sessions, shares of the two companies skyrocketed, bringing their market cap to more than $20 billion. However, within a few days, the shares declined, pushing many retail investors to lose billions of dollars. This is a classic example of a pump and dump scheme.

While these schemes are popular in the stock market, other assets are also victims. Indeed, during the so-called Wall Street Bets (WSB), pump and dump schemes happened in the commodity and cryptocurrency market. In commodities, traders pumped silver, while in the crypto industry, they placed bets on Dogecoin.

How pump and dump schemes work

The idea behind these schemes is relatively simple. In fact, it has been around for decades. First, an investor, analyst, or a group of them identify a relatively cheap asset. They buy these assets, which pushes their prices higher. 

Second, they start promoting the assets using social media. Some even pay adverts to lure more investors into the assets. This process also pushes their prices higher. Finally, after achieving a substantial return, they start selling the asset. They leave the rest holding an asset that is not worth it. 

This process is similar to the popular Dow theory. After a careful analysis of the stock market, Charles Dow realized that they usually move in phases. In the first phase, the market starts rising slowly. In the second stage, it catches the eye of investors, who rush to buy it. In the final stage, there is distribution, where the investors start to sell. 

How to identify pump and dump in stocks

There are several strategies that can help you identify and avoid these schemes in the market.

Be careful about companies you don’t know

As a day trader, one way of avoiding these schemes is to be careful about companies you don’t know. In most cases, pump and dump schemes happen in vague companies that you have never heard about. Also, these firms are mostly penny stocks that trade at less than $5 per share.

The idea behind this is relatively simple. These companies usually have a low share price, meaning that a schemer can buy thousands or millions of shares at once. This action will lead to a higher volume in the stock, pushing the stock price higher. 

On the other hand, it is almost impossible for such schemers to move big companies like Microsoft and Apple that move billions in volume every day. Some of the strategies you can use are:

  • Learn more about the company. Google can help you with this. 
  • Use platforms like Yahoo Finance and SeekingAlpha to view its earnings and other financial statements.
  • Read their previous news history. 

Be careful about press releases

Many pump and dump actors use press releases to move their stocks. They will come up with a well-written press release and pay the most credible distribution channels like BusinessWire. For example, they will publish a PR talking about a new upcoming product or speculate a merger and acquisition (M&A) deal. 

In line with this, avoid companies that are being hyped by celebrities. Also, avoid investing recommendations from people you don’t know.

Investigate any sharp moves

Another simple way of identifying pump and dump schemes is to investigate any sharp moves in a stock. For example, when you see a stock rallying, understand why this trend has happened. Fortunately, there are many free and credible ways of getting this information. For example, you can conduct a Google search for a company and find the most recent news. Be careful if there is no major news.

Also, always look at volume trends. Many online brokers provide their customers with free volume data. Others provide their traders with in-depth level-2 and time and sales tools. You should use these tools to analyze the flow of volume in and out of stock. Avoid buying a stock whose rally is not supported by sizable volume.

Research assets well

Finally, you should always research the asset you want to invest in well before you invest. For example, in the case of a stock, check the Securities and Exchange Commission (SEC) database for more information. Also, dig deeper into the company’s earnings, analysts’ coverage, and its ownership. In the case of a cryptocurrency, we recommend that you also dig deeper into what is being sold. 

Most importantly, always use proper risk management strategies when identifying pump and dump stocks. Some of these include using limited leverage, having a stop loss, and always investing in what you know well.

Final thoughts

There is no clear data on pump and dump schemes in the United States. Some analysts believe that these schemes cost Americans billions of dollars every year. Globally, the number is substantially higher than that. As explained, these schemes are usually highly sophisticated, and at times, even the most experienced investors are victims. Being careful, avoiding hype, and verifying every claim can help you make good decisions.