Pump-and-Dump Scheme

Definition

A pump-and-dump scheme is a fraudulent practice in the stock market where the prices of a stock are artificially inflated, often through misleading or overly positive statements (the ‘pump’). Once the stock prices have increased, the fraudsters sell their shares at the inflated price (the ‘dump’). Afterwards, the price typically crashes, leaving other investors with significant losses.

Phonetic

The phonetics for “Pump-and-Dump Scheme” is as follows: /ˈpʌmp ænd ˈdʌmp skiːm/

Key Takeaways

1. Illegality and Fraudulence: A Pump-and-Dump Scheme is an illegal and fraudulent practice where the prices of a stock, usually in a small and obscure company, is inflated artificially. It involves tricking investors into buying shares at the pumped prices.

2. Price Manipulation: The orchestrators of a Pump-and-Dump Scheme manipulate stock prices by spreading false or misleading statements to create a buying frenzy that will ‘pump’ the price of a stock up, and then ‘dump’ shares of the stock by selling their own shares at the inflated price.

3. Financial Loss for Investors: Once the operators of the scheme ‘dump’ their overvalued shares, the price falls and investors lose their money. These schemes are usually undertaken by experienced traders who are aware of the effect their actions will have on the market.

Importance

The business/finance term “Pump-and-Dump Scheme” is crucial because it refers to a fraudulent practice that can lead to significant financial losses for investors. The scheme is primarily associated with the stock market where manipulators or insiders inflate (“pump”) the price of a stock through misleading positive statements or other deceitful promotions, effectively creating a false market. As the unsuspecting investors buy the stock and increase its price, the fraudsters sell their shares (“dump”) at the inflated price. When the scheme is exposed or the promotion stops, the stock price typically crashes, leaving the deceived investors with worth-less stock. Awareness of this term and scheme can help investors to be cautious and avoid falling victim to such manipulative practices.

Explanation

A pump-and-dump scheme is a fraudulent practice typically involving the artificial inflation of a stock’s price to attract investors, after which the fraudsters will sell their overvalued shares—resulting in a significant profit. The purpose of this scheme is to manipulate the price of a stock, usually of a small-cap company, in a way that benefits the scheme initiators at the expense of misled investors. By disseminating false or misleading information through various channels such as chat rooms, email newsletters, or social media, these individuals aim to create a buying frenzy among uninformed investors and cause the stock price to skyrocket or “pump.”Upon reaching a peak, the fraudsters behind the scheme then “dump” their shares, realizing substantial gains from the artificially high pricing. As they sell off their shares en masse, the price of the stock rapidly falls, often leaving those who were attracted by the false hype with significant losses. Unfortunately, these naïve or less experienced investors are often left with worthless, or near worthless, shares. It’s important to note that pump-and-dump schemes are illegal and punishable by law under securities fraud and manipulation charges.

Examples

1. Stratton Oakmont, Inc.: Perhaps the most famous pump-and-dump scheme was conducted by Jordan Belfort, known as the Wolf of Wall Street. Through his firm, Stratton Oakmont Inc, Belfort would purchase large amounts of penny stocks at a small price and then aggressively market them to inflate their value. Once the stocks reached a high price, Belfort would then sell his shares and stop promoting the stocks, causing their value to plummet and investors to lose money.2. Centra Tech ICO: In 2017, cryptocurrency startup Centra Tech raised over $25 million in an initial coin offering (ICO). The founders, Sam Sharma and Robert Farkas, made false claims about their product and partnerships with legitimate businesses. They used celebrity endorsements to pump their stock value before dumping, they were arrested and charged with fraud in 2018. 3. Enron: While not a typical pump-and-dump scheme, Enron is still a perfect example of how companies can artificially inflate their stock prices. The energy company manipulated its financial statements to present a misleading picture of its financial health. This boosted Enron’s share price to over $90 at its peak. When the reality of Enron’s finances became public knowledge, the stock price plummeted, dropping below $1 per share and causing massive losses for investors. Enron’s top executives were prosecuted for their roles in the fraud.

Frequently Asked Questions(FAQ)

What is a Pump-and-Dump Scheme?

A pump-and-dump scheme is a fraudulent tactic utilized in the stock market where the price of a security is artificially inflated, or pumped , to attract unsuspecting investors. Once the price reaches a certain level, the fraudsters dump their shares selling them off at the inflated price, which typically leads to a rapid drop in price and significant losses for the misled investors.

How does a Pump-and-Dump Scheme work?

Initially, scammers buy a large volume of low-priced shares. Then, they create hype around the stock, often through false statements and misleading information, to attract investors and increase the stock’s price. Once the price is sufficiently inflated, the fraudsters sell all their shares for a profit, causing the price to plummet and investors to lose money.

Is the Pump-and-Dump Scheme illegal?

Yes. Pump-and-dump schemes are illegal and considered securities fraud. They violate laws related to the manipulation of securities’ prices. Perpetrators could face civil and criminal penalties.

How can I identify a potential Pump-and-Dump scheme?

Indications of a potential pump-and-dump scheme include an unexpected and rapid increase in a stock’s price, unusually high trading volume, aggressive or misleading promotional material, and lack of credible information about the company.

Why should I avoid pump-and-dump schemes?

In most cases, you will lose money if you invest in a pump-and-dump scheme. Not only are these schemes illegal, but they can also have serious financial ramifications.

Where are pump-and-dump schemes usually found?

Pump-and-dump schemes are more common in less-regulated markets or over-the-counter markets. These markets have less oversight, making them more susceptible to manipulation and fraud.

How can I protect myself from pump-and-dump schemes?

Protection measures include doing thorough research before investing, being skeptical of unsolicited stock advice, avoiding stocks that exhibit signs of a pump-and-dump, and reporting suspicious activity to regulators.

Who regulates pump-and-dump schemes?

In the United States, the Securities and Exchange Commission (SEC) regulates the securities industry and works to protect investors from fraudulent activities such as pump-and-dump schemes.

Related Finance Terms

Market Manipulation
Fraudulent Stocks
Security Fraud
Insider Trading
Penny Stocks

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