What is a pump and dump stock, and how do you trade them?

What is a ‘pump and dump’?

A pump and dump is a scheme that involves a group of investors – or singular investor – artificially inflating a stock’s price, and then selling the stock once the price has risen. Artificial inflation is usually achieved by spreading false, dishonest, or hyperbolic claims about the stock (the ‘pump’).

Once the stock has reached a favourable high, the investors sell the stock (the ‘dump’) to reap the rewards. This is done at the expense of other investors – usually vulnerable groups of people – and their capital.

How does a pump and dump work?

Pump and dump schemes normally focus on micro-cap stocks (penny stocks) or lower-market cryptocurrency coins. These micro-cap assets are typically traded over-the-counter (OTC) or in grey markets, are opaque and feature a low price per unit. They may also not be expected to follow public listing requirements.

These conditions make it a perfect opportunity for manipulation. With very little company information available to the public, potential investors are unable to follow their due diligence and research the stock properly – allowing these schemes to gain traction.

Additionally, the prices of these stocks can be inflated easily due to their illiquid nature and low trading volume. In certain circumstances, these stocks may be in shell companies created solely for the purposes of market manipulation.

The stock selected for the pump and dump would be promoted as a ‘blink and you’ll miss it’ investment opportunity, the ‘next big thing’ or a ‘hot tip’. These statements would seem like a genuine source of insider knowledge and would normally be followed by the claim that an anticipated news announcement will provide a huge boost to the stock’s price.

What is unknown to the public is that these insiders would be buying small amounts of the stock over a long period to prepare for the dump, once the rush to purchase is well and truly underway.

After all of this planning is complete, the parties behind the scheme would then initiate the pumping phase, after which they would dump the stock to realise a sizeable profit.

In the past initiators of schemes would use methods like cold-calling, fake news releases, ‘accidentally placed’ voicemails and email spam. Currently, popular tools include social media and the use of online social messaging platforms (eg Discord and Telegram).

Pump and dump example
So, how does a pump and dump scheme work in practice? Let’s say during May, the fictitious micro-cap stock Summer Holiday fell victim to a pump and dump scheme, initiated through a fake tip posted on Discord and social media. This tip was posted on various Facebook groups and Discord chat servers, promoting a stock promising exponential growth due to insider knowledge.

The chart above shows the dramatic price increase in a weekly period, from 32p to 150p – which is an increase of nearly 370%. At the same time as this large price increase, there was an equally large volume increase. The stocks, which usually had an average daily trading volume of under 200,000, had seen an increase of up to 1.5 million shares during the lead up to, the days of and the days after the pump and dump. This is demonstrated in the chart below.

For the unsuspecting investor caught up in the scheme buying in at around 150p, they would have to sell their stock after the dump at a price of around 40p – equating to a loss of over 70%.

Pump and dump stocks: what are the benefits and risks?

Benefiting from pump and dump stocks is not impossible. It requires being quick on the uptake and riding the trend in the opposite direction. While pump and dump stocks are inherently risky, they can also be a great way to take advantage of market volatility – provided you are using the correct strategies and risk management. However, this can only happen if you are wise to the early momentum of a pump and dump stock.

Before entering a trade of this nature, understand that this is an extremely risky strategy that requires caution. With a quick change in market direction when the dumping begins, the fast-moving momentum could provide room for large losses.

A way you could potentially take advantage of the stocks coming down is by short selling them. Short-selling does incur additional risks, but if you can sell your shares at the height of the pump, and then buy back the shares at the low of the dump, you could make a healthy profit.

How can you trade or invest in pump and dump stocks?

There are two methods you could employ in pump and dump trading: going long on the pump and shorting the dump.

Go long on the pump

The main focus of this strategy is to go long on stocks by pre-empting the dump (or sell-off). The trick to this strategy is not to buy too early to avoid your capital sitting in a stock that only has a minimal increase before it is dumped.

How would you find the right stocks? Well, just like social media and instant messaging platforms are hosts to pump and dump schemes, these tools also provide insight into which stocks are trending or gaining the most hype.

Once you have located a stock with significant hype, you will assess the volatility of the stock. Does this asset show large gains in a single day – growth of 25% or more? If it’s less than 25%, it is unlikely to display rapid growth in the future, and may just be depicting growth typical of its daily cycle.

If you have identified a stock that meets the above criteria, and it consistently displays the criteria over some time (and not just one day), it may be time to consider enacting your trade. On the next trading day, buy at a break of the first day’s highs.

Importantly, be prepared to sell your position within the next few days –specifically to sell when it is not at its peak. Rallies typically last from three to five days, and this means you can’t become attached to the trade. Keep an eye out for an opportune moment to sell. You will not be able to make the maximum profit on the trade, as you are not the one who initiated the scheme.

Let’s consider you want to open a CFD trade* to go long on the fictitious company Summer Holiday:
a. Click on the correct share to open its deal ticket, and choose the ‘buy’ option
b. Enter a deal size, and select your stop loss to prevent slippage
c. Click on the ‘place deal’ tab to set your position to open
d. Monitor your new trade on the chart or the ‘positions’ panel

Ensure your practice your strategy before putting your capital at risk, by opening a demo account with us.

Short the dump

This method builds on the benefits of trading pump and dump stocks. Shorting the dump requires expertise and skill, but will provide a quick and potentially profitable the trade. Once the stock begins to break away from the pump, you will begin to short the stock. Be wary, the scheme may encourage further pumping and you may have shorted the stock too quickly.

Say you wanted to open a spread bet* on Summer Holiday shares to short them:

a. Locate the Summer Holiday shares to open its deal ticket, and choose the ‘sell’ option
b. Enter a bet size, and define your closing conditions
c. Select ‘place deal’ to confirm your spread bet
d. Manage or view your new position in the chart or the ‘positions’ panel

Please note this is a tricky trade to pull off, and requires your timing to be perfect.
Practice is essential. If you feel you are ready to explore the risky world of trading, try opening a live account to get started.

*With spread bets and CFDs, you don’t take ownership of the underlying shares but instead speculate on their price. Your profit or loss depends on the outcome of your prediction. This means you can trade rising and falling markets with these derivative products. Both are also leveraged, so you’ll outlay an initial deposit (called margin) to open a position.

In other words, you can open a trade for less – just remember, leverage comes with increased risk as your profit or loss will be calculated on the total position size rather than your margin amount.

CFDs and spread bets are complex instruments. You can lose your money rapidly due to leverage. Please ensure you understand how this product works and whether you can afford to take the high risk of losing money.

Hedging against pump and dump stocks

So, how do you protect your investments if stocks in your portfolio form part of a pump and dump scheme? Well, by adopting a hedging strategy with a leveraged trading account, you can offset some of the short-term volatility that comes with such a scheme.

Let’s say you take advantage of the example pump and dump scheme involving the fictitious company Summer Holiday. You may decide to hedge against the risk of owning shares in the company by trading CFDs and spread bets* on the same asset. This method would follow similar processes as the trading strategies mentioned above: going long during the pump phase and shorting the stock during the dump phase.

Always keep in mind:

• Be wary of unsolicited investment offers – usually through the channels discussed above
• Look out for red flags – does it sound too good to be true, or like a guaranteed win?
• Look out for affinity fraud – this targets vulnerable professional and social groups
• Partake in due diligence and research
• Make use of stop-losses, limit orders and other risk-protection tools

Pump and dump in trading summed up

• Pump and dump schemes are created to take advantage of vulnerable investors
• By artificially inflating a stock’s price, then selling off to create a rapid decline, these schemes can generate significant profits for their originators
• Once you are aware of these pumping and dumping cycles, you too can navigate these volatile market movements