Definition
“Pump and dump” is a fraudulent practice involving the artificial inflation of a company’s stock (the “pump”) through false or misleading statements. Once the stock prices have been inflated, fraudsters sell off their shares at the increased prices (the “dump”). Subsequently, the stock typically crashes, leaving unwitting investors with significant losses.
Key Takeaways
- Pump and Dump refers to a scheme that attempts to boost the price of a stock through recommendations based on false, misleading or greatly exaggerated statements. The perpetrators of this scheme, who already have an established position in the company’s stock, sell their positions after the hype has led to a higher share price.
- This practice is illegal due to its fraudulent nature, it manipulates the market taking advantage of unsuspecting investors who might be attracted by the false hype and promise of significant returns. Regulated markets in many countries have strict rules against pump and dump schemes.
- The victims of a pump and dump scheme often end up with worthless stock after the perpetrators have sold off their shares and the hype dies down. Investors are advised to do their own due diligence before investing in a stock, particularly one that has displayed unusually rapid growth or has been recommended based on the promise of spectacular profits.
Importance
The finance term “Pump and Dump” is important as it refers to a fraudulent practice in the stock market where the price of a security, usually of a small, less publicly known company, is artificially inflated, or “pumped up”, typically by false and misleading positive statements. This creates a speculative frenzy, causing the price to significantly rise.
Once the price has peaked, the fraudsters then “dump” their shares at this high price, leading to substantial gains. Subsequently, the stock price crashes, leaving innocent investors with worthless shares.
Hence, it’s a critical term in ethical investment and finance circles as it represents a form of security fraud, which is illegal, destructive to markets, and harmful to investors.
Explanation
The purpose of the “Pump and Dump” strategy is essentially a fraudulent scheme, primarily used in stock market trading, where promotors manipulate the price of a particular security for their profit. It is orchestrated by inflating or ‘pumping’ the price of the security through false and misleading statements, often about a major breakthrough or fantastic financial results, leading to an artificially inflated demand.
This hype can cause unwitting investors to buy shares at inflated prices, leading to significant profits for the perpetrators. The second phase, ‘dump,’ takes place when the manipulators have successfully inflated the stock’s price and reached their profit peak.
They ‘dump’ or sell their shares at the heightened price. The sudden sell-off leads to a drastic drop in the stock’s value, causing massive losses for those who bought the stock during the ‘pump’ phase.
It’s important to note that the Pump and Dump technique is illegal and unethical, given the severe financial losses it can cause to unwary investors.
Examples of Pump and Dump
Stratton Oakmont and Jordan Belfort: Infamously dramatized in the movie “The Wolf Of Wall Street”, Jordan Belfort and his brokerage firm Stratton Oakmont manipulated the price of many penny stocks in the late 1980s and 1990s through aggressive telemarketing techniques. They would inflate the price of a stock (pump) and then sell their position at a great profit (dump), which often left many investors with significant losses once the price plummeted.
ZZZZ Best: The infamous ZZZZ Best fraud case in the mid 1980s involved Barry Minkow, a teenager who started a carpet cleaning company in his parents’ garage. Minkow was able to build his company to valuation of $200 million by creating fictitious restoration projects and pumping the stock. He then dumped the stock at its peak, before the fraudulent activities associated with the company were exposed.
The Enron Scandal: Regarded as one of the most notorious cases of corporate fraud and corruption, Enron manipulated energy prices to create artificial profits, then spread false information to inflate stock prices. Their executives sold their stock at inflated prices (dump) before the truth came out and the company collapsed, leaving many employees and investors with worthless stock.
FAQs on Pump and Dump
What is a Pump and Dump?
A Pump and Dump is an illegal scheme often practiced in the stock market where the price of a security is artificially inflated, or ‘pumped up’, typically by false and misleading statements. Once the security reaches a certain inflated price, the fraudsters sell off, or ‘dump’, their shares at these high prices and make substantial profits. This often leads to the security’s price falling dramatically, causing substantial losses for those who purchased based on the fraudulent promotion.
How can I identify a Pump and Dump scheme?
There are several red flags that might suggest a Pump and Dump scheme. These include a very sudden spike in share price or trading volume, aggressive promotional tactics, pressure tactics to buy urgently, and false or misleading statements about new business developments. It is also typically associated with smaller, less-known companies.
What’s the impact of a Pump and Dump scheme?
Investors who become victims of a pump and dump scheme can lose considerable money when the fraudsters sell their shares and the price falls. The sudden sell-off can leave the investors with worthless, or nearly worthless, stock.
Are Pump and Dump schemes illegal?
Yes, Pump and Dump schemes are illegal. They are a form of securities fraud and can attract severe penalties, including fines and imprisonment.
How can I protect myself from a Pump and Dump scheme?
Investors can protect themselves by conducting thorough research before investing, being skeptical of unsolicited investment offers, avoiding high-pressure sales tactics, and getting independent advice if unsure. Always consider consulting with a trusted financial advisor before making an investment decision.
Related Entrepreneurship Terms
- Market Manipulation
- Microcap Fraud
- Securities Fraud
- Penny Stocks
- Insider Trading
Sources for More Information
- U.S. Securities and Exchange Commission (SEC): The SEC is a government agency that protects investors and maintains fair, orderly, and efficient markets. It’s a reliable source for information about financial terminology and practices, including pump-and-dump schemes.
- Investopedia: This site provides investors with comprehensive, high-quality resources including definitions, explanations, and examples of various finance and investing terms.
- Federal Trade Commission (FTC): The FTC is a government agency tasked with protecting consumers and competition by preventing anticompetitive, deceptive, and unfair business practices. Their website has information on a wide array of topics, including pump-and-dump schemes.
- Federal Bureau of Investigation (FBI): The FBI investigates and reports on a variety of criminal activities including securities and commodities fraud. Information about pump-and-dump schemes can be found in their resources.
