How to spot a pump and dump scheme

The value of your investments and the income you receive from them can go up and down, and you may get back less than you invest. Any examples are for illustration purposes only.

If you’ve been around the market block you’ll have seen at least a couple of instances where a stock suddenly shoots higher, garners a lot of attention and swiftly drops right back to where it was in the blink of an eye. Just a normal bout of market exuberance and underlying business success? Maybe. Sometimes there’s something a bit more to it.

A pump and dump scheme is where a stock is suddenly forced higher, seemingly out of the blue, only for the price to crash soon after. Behind the scenes, groups of market manipulators or dishonest company insiders circulate fraudulent or misleading information about the stock to draw in investors. They heavily promote the shares and often coordinate large buying sprees so the stock rises, selling large volumes of their own stock to bank a profit at the expense of other investors who end up watching the stock plummet.

1. The pump

To drum up excitement around a stock, a group of investors will often start spreading outlandish claims about the company - a new product, a high profile contract win or a rumoured buyout are all common narratives. Sometimes an exec of a struggling company might misstate or flat-out lie about company accounts or suggest some sort of merger or sale of the business is on the cards.

2. Generating hype

Social media, online forums, Telegram, Discord and WhatsApp group chats - you name it, they’ll use it to fuel the story and create an echo chamber that constantly swells support for the seemingly ‘amazing’ opportunity ahead. There doesn’t tend to be much substance or valuation sensitivity in these chats; instead the message tends to be ‘buy at all costs’.

3. The dump

With the growing exuberance lifting the stock higher and higher, the initial manipulators sell up and disappear. They often have enough shares that their sales have a meaningful downward force on the stock, sending it right back to where it was before they got involved. Other investors caught up in the hype can be left with large losses.

With the growing impact of platforms like Reddit on retail investing, it’s important to point out that not all research or positivity around a stock is fraudulent. That makes the job of spotting bad actors even more difficult. Here are a few things to keep an eye out for to help figure out if a pump and dump scenario is being created.

Sudden and unexplained spike in share price

Big movements in the stock with no news or increased earnings should arouse a healthy suspicion. It could be a sign that manipulators have more influence on the stock than news-based assessments of the company’s future value.

Coercive promotion of the stock

The classic exaggerated claims guaranteeing returns and warning you not to miss out on a “once in a lifetime opportunity” start to hit your inbox. No investor can be sure of returns and we should always be wary when others try their hardest to involve us; what’s in it for them?

Outsize interest in stocks with small market capitalisations

Manipulators often choose small-cap stocks to promote, as these share prices can be easier to influence if there is a sudden rush of buying from retail investors.

There’s a lot of excitement but not much solid fundamental justification

If you’re struggling to match the story around the stock with the accounts, recent growth or concrete route to higher earnings, pause for breath. These are the building blocks of any company and often any questions around the investment case are brushed aside or harshly treated in online groups.

Large volumes of insider selling or share issuance

If a firm is artificially inflating its share price, it might take the opportunity to issue new shares or get rid of their own stock, capitalising on the hype before any crash.

New or inexperienced promoters appearing

It’s always worth asking where these new, particularly opinionated, fans of the stock have come from. If they are constantly pumping the stock with limited or no pedigree in investing to speak of, think about avoiding their enthusiasm and concentrating on your own research.

• Watch out for companies being promoted, whose revenues are low or non-existent. Has the company reported news that could change this and can it be justified, or is something else driving the share price?
• Check the shareholder register - are there legitimate fund houses on board or are institutions avoiding the stock?
• Are reputable sources analysing and assessing the stock or is there a small but forceful group promoting it?
• Is the company profitable? Does it have a track record of delivering consistent profits?
• Does the business model make sense or are vague, jargony buzzwords obscuring how the company actually makes its money?
• Are ‘fans’ of the stock pushing investors to take excessive risk and invest heavily in the company? It shouldn’t matter to anyone else how much you invest - be sceptical if they want you to invest more.

A final point is to stay sensitive to a company’s valuation. Sometimes a stock genuinely does have a positive catalyst helping lift revenues, in which case it gets a bit harder to tell if a stock is rising because of credible business improvement or manipulated hype. It’s why we all need to be aware of how well a share price reflects the value being created. If you start to see price-to-earnings (P/E) ratios in the hundreds, ask yourself how realistic that is and if earnings really can rise that much to justify the price. If it looks too good to be true, it quite often is.

Important information

When investing, your capital is at risk. The value of your investments, and the income you receive from them, can go down as well as up and you may get back less than you invest. Forecasts aren’t a reliable guide to future results or returns.

Make sure to do your own research on what investments are right for you before investing or consider seeking expert financial advice. Please note that this article is meant for information and does not constitute any financial advice. This is not an offer, recommendation, inducement or invitation to buy, sell, or hold any securities, or to engage in any investment activity or strategy.