Pump and Dump Schemes: Protecting Your Investments in Stock Trading

Stock trading has long been a favored avenue for investors to grow their wealth, offering options for both short- and long-term investing. However, the allure of quick profits in the stock market also exposes investors to various fraudulent stock trading schemes. 

One of the most notorious of these schemes is the “pump and dump” scheme. Whether you’re considering getting into the stock market or already own a portfolio of stocks, it’s important to understand how to protect your investments from pump-and-dump scams.

What Is a Pump and Dump Scheme?

A pump and dump scheme is a fraudulent practice — more specifically, a type of securities fraud — that involves artificially inflating the price of a stock to attract unsuspecting investors. 

Once the stock’s price has been artificially pumped up, the orchestrators of the scheme quickly sell their shares, causing the stock’s price to plummet. 

This leaves those who bought in at the inflated prices with significant losses while the scammers make a hefty profit. They then rinse and repeat for another stock.

How Do Pump and Dump Schemes Work?

Pump-and-dump scammers usually choose micro- and small-cap stocks because they are easier to manipulate the prices of. They also often choose stocks that are available on over-the-counter securities exchanges, as these are less regulated.

Once the scammers have picked a stock to pump and dump, their pump-and-dump scheme works like this:

1. Promotion

The first stage of a pump-and-dump scheme involves promoters who disseminate false or misleading information about a particular stock. They may use various channels such as social media, online forums, newsletters, or even cold-calling to tout the stock’s supposed potential. 

These promotions often greatly exaggerate the company’s prospects for near-term profits, making it seem like a once-in-a-lifetime investment opportunity.

2. Price Inflation

As the stock gains attention and more investors rush in to buy, the demand for the stock increases, causing its price to rise. This creates a self-fulfilling prophecy, as more people are enticed to jump on the bandwagon, further driving up the price.

3. Sell-Off

Once the stock price reaches a certain level or the schemers feel they’ve attracted enough investors, they start selling their own shares, taking advantage of the inflated prices. This sudden influx of shares into the market puts downward pressure on the stock’s price.

4. Investor Losses

With the schemers out of the market and the artificial support removed, the stock’s price usually crashes. Investors who bought in at the inflated prices are left with substantial losses, while the orchestrators of the scheme walk away with their ill-gotten gains.

How To Protect Your Investments from Pump and Dump Schemes

Conduct Due Diligence

The first and most crucial step to protect your investments is to conduct thorough research. Always investigate the companies you are considering investing in to make sure any information you may hear about them from third parties is legit. 

Look for reliable sources of information, such as financial statements, news articles, and reputable financial analysts’ reports. Avoid making investment decisions based solely on tips from unknown sources.

Beware of Hype

Be cautious of stocks that are aggressively promoted with grandiose claims. If a stock is being touted as a “can’t-miss opportunity” or a “surefire winner,” it’s a red flag. Legitimate investments rarely require such aggressive promotion, and there are no guarantees in stock investing.

Verify Information

Verify the accuracy of any information you come across, especially if it’s sent or provided to you out of the blue from unknown sources. 

Check whether the company’s financials and business prospects align with the claims being made. Be especially skeptical of claims that lack concrete evidence or rely on vague promises.

Avoid Micro- and Small-Cap Stocks

Micro- and small-cap stocks are more volatile and more susceptible to pump-and-dump schemes. Unless you’re an experienced day trader, it’s better to avoid these types of stocks and focus on investing in large-cap stocks, which are more stable.

Watch for Pumping Signals

Keep an eye out for unusual trading activity, such as a sudden spike in trading volume or a rapid increase in a stock’s price with no clear fundamental reason. These can be signs of a pump and dump in progress.

Set Realistic Expectations

It’s essential to have realistic expectations about your investments. Understand that the stock market involves risks, and no investment is guaranteed to produce substantial gains in a short period. Avoid the temptation to chase after stocks that promise quick riches.

Diversify Your Portfolio

Diversification can help spread risk across different assets, reducing your exposure to any single investment. By holding a diversified portfolio, you are less likely to be severely impacted by the downfall of one stock due to a pump-and-dump scheme.

Use Stop-Loss Orders

Implement stop-loss orders when trading stocks. These orders automatically sell your shares if the stock’s price falls to a specified level. While they can’t prevent losses entirely, they can limit the extent of your losses in case a pump-and-dump scheme unfolds.

Report Suspected Fraud

If you come across a suspected pump-and-dump scheme, report it to the appropriate authorities, such as the Securities and Exchange Commission (SEC). 

Reporting fraudulent activity can help protect other investors and potentially lead to legal actions against the perpetrators.

Wrapping Up

Pump and dump schemes are a dark side of the stock market that prey on unsuspecting investors seeking quick profits. 

Since this type of fraud revolves around real stocks, it can be easy for unsuspecting new investors to fall for a pump-and-dump scam in the hopes of turning a quick profit.

However, it’s important to remember that, as with any type of investment opportunity, if it sounds too good to be true, it probably is.

Newer investors should focus more on stable, long-term investments, as well as implement the other best practices we discussed above, to avoid pump-and-dump scams and protect their hard-earned investment money from scammers.