Pump and dump defined

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An illegal profit-making scheme for inflating a security price using false and misleading information

Fake gold paint being applied to black rocks                                 
All that glisters is not gold when it comes to pump and dump schemes – Photo: Shutterstock
                                

Pump and dump explained

Pump and dump strategy is a fraud used by investors to artificially increase the interest in security they own, by promoting misleading and unrealistic information about the actual value of a specific financial asset.

In a pump and dump strategy, investors hold a long position. Therefore, their objective is to inflate the price and sell the stock at the pumped-up price, making an extraordinary return. When the target price is achieved, they dump their stocks. After the sale, the price is dipping downwards and other investors (who are not part of the scheme) lose their money.

Pump and dump meaning

The pump and dump scheme is an illegal activity and is subject to sizeable fines. It is used for market manipulation – by overestimating the true value of a stock, potential investors are misinformed about the statements and earnings of a company.

This scheme is usually associated with small publicly traded stocks categorised as penny stocks or stocks with small capitalisation. These stocks are traded at a price of €1 or lower. Sometimes stocks used in the pump and dump actions are referred to as ‘chopsticks’. The price of these stocks records a drastic increase over a short period of time as a result of the rapid growth of demand.

What is pump and dump?

This fraud begins with the purchase of stocks of a specific company. After that, investors are starting a campaign to manipulate the market about the true value of the stock. They try to persuade other investors that the stock is undervalued or that the value of the company will drastically increase.

Investors employ different strategies to ‘inform’ the market about the new ‘golden’ stock. It can be email marketing, social media, traditional marketing campaigns, press releases, an inside information conversation, or many more methods.

The scheme can also be executed through a small brokerage firm hiring brokers for the purpose of promoting the stock to potential investors. They can have the role of a market maker, creating interest for a specific stock using cold calling. After a larger number of investors buy the stock, the market sees a sudden increase in the demand for an anonymous stock. When the price is inflated enough, the fraudulent investors dump.

Further reading

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