Introduction to Pump and Dump
The term ‘Pump and Dump’ is a method using which the price of shares in the open market will be inflated to the benefit of management holding influential control over the company, in other words, the share price will rise to such levels by spreading some positive news about the company and take the advantage by selling holdings at such raised prices.
Explanation
The explanation of Pump and Dump is as follows:
- The shares of the company must be registered on the trading platform.
- The individual or group of people are insignificant control position which means they have a major role to play in any decision of the company.
- They must hold such majority share of holding of shares of the company so that the sell-off by them will result in fall in prices of share.
- Then such group of a person spreads some positive news such as good results, or acquisition of the company by some major group, major investments are going to be made by govt, etc. which positively impact the prices of share in the open market.
- Then sell-off their holdings and earn such good returns from such holdings.
How do Pump and Dump works?
The pump and dump scheme could mostly be done with penny stocks which means such stocks whose market share is limited and very less and most of the holdings of such stocks are held with management itself. These shares are generally traded at such low prices which attracts the new entrants mainly who did not have knowledge of investment but found such share because of price of share. Such companies also do not take care of listing guidelines because they are only listed with the objective of taking such benefit by manipulating the price.
Because of such a small company, the information or rumours can easily be manipulated by its management and due to small company, such companies also did not provide much information in the public domain which thereby bounds the investor with limited information only. Then the management starts spreading such major positive news about the company which instantly impact the price of a share and starts to rise sharply.
Examples of Pump and Dump
The Company XYZ Inc. has a share capital of 500,000 shares which are currently traded at $500 per share in the open market. The management of the company holds 45% of the holdings with them. The financial results of quarter 3 of the year are yet to be declared by the company in the coming week after being adopted in the general meeting of the company. Now, to take the advantage of such a situation management personnel has started spreading rumours that the company has earned 150% more profits as compared to last quarter and could consider declaring dividend also in the results of the company.
After this news reaches open market the other common trading member starts buying the share from the open market to take the advantage of such results as good results will surely raise the price of a share in the open market and the buying pressure created will increase the price of the share in the open market say to $750. Now, after the share attains a level the management start selling their holding i.e. 45,000 shares at such raised prices i.e. $750 which increases the supply of the shares resulting in the downfall of the price of share and loss for the new entrants who have purchased the share at such high prices.
Types of Pump and Dump
The types are as follows:
- The first type of such a pump and sump technique is to flow such information about the company which is wrong but will have a positive impact upon share prices.
- The next practice is of creating bogus demand of the shares of the company i.e. some brokering house will be appointed who will create bogus demand of the shares and not offering any share of the company for sale which results in the price of the share.
How to spot Pump and Dump scams?
The scams could be easily spotted by performing some due diligence before investing hard-earned money in such bogus situations which are as follows:
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- The share is trading at a very low price for a long period.
- The financials of the company represents not such good profits which could raise the price of a share.
- The management started increasing their holding by purchasing shares from the open market.
- The sudden positive news about the company starts blowing.
- The sudden rise in a number of buyers will be seen.
- The situation of shortage of supply of share in the open market to sale will be created.
- The financial and performance charts of the company will show a sudden rise in prices of share.
Reasons for Pump and Dump
The reasons are as follows:
- The technique of pump and dump is only used with the intention of the rise in the price of the share of the company to such high levels and then sell off the holdings held for earnings high inflated profits and selling off thereby results in decreasing the price of the share at which they could also repurchase the shares sold suppose for instance a company ABC Inc. has a share capital of 100,000 shares and Mr. A holds 45,000 shares of company ABC Inc. which is currently trading in the open market at a price of $100 per share then by spreading such rumors the price of shares got rises to $150 per share then Mr. A has sold all his 45,000 shares and due to heavy sell-off the price again comes to $80 per share then Mr. A has repurchased his holding of 45,000 shares results in net profit of $70 per share.
- Through this technique, the person could be able to earn riskless profits which are generated by some internal person itself to take advantage of the position held.
Conclusion
To conclude, the term ‘Pump and Dump’ it is a technique used by those who have significant influence over the performance of the company and has a significant market share as well, in other words, it can only be executed by those persons who have influence over the company which could either be in form of having more than 20% market stake of shares or having 20% or more voting powers which thereafter be used to manipulate the general public by spreading some positive rumors about the company for taking advantage of price rise.
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