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Understanding a Pump and Dump Scheme

Updated on June 27, 2011

What is a Pump and Dump?

"Pump and dump" is a fraudulent stock trading technique. The scheme begins by the conspirer buying mass quantities of speculative, unknown, or suspect stock from a company of little value. This will subsequently raise the price of the given stock tremendously. The idea is to deliberately and artificially inflate the price of a stock. Then through a campaign of false and misleading advertisement, entice victims to buy into the same very stock, in which you (the conspirer) were previously invested into at a much lower price. Once the conspirers of the scheme "dump" their overvalued shares, the price falls and investors lose their money. Stocks that are the subject of pump and dump schemes are sometimes called "chop stocks".

A simple of example of how a pump and dumb could mischievously work to my benefit is buying up to 1000 shares of a penny stock. I then deceptively spam an e-mail newsletter or broadcast on a social networking site crying out the benefits of this given stock. People who research the stock subsequently see the stock increasing in both sales volume and price. People are then tempted to buy into the stock, incorrectly assuming my information is based off sound research. After taking no more than an hour spamming a few websites, the stock's volume goes up from 1000 shares to 2000 shares, and as a result, more than doubles in value. At this point, I pull the trigger, selling all my 1000 shares. The dire consequences is the stock is now abruptly diminished in value by half, while I sold my shares at twice their original value no more than a few hours ago, effectively doubling my profit every time I pull off this scheme. The end result for the combined investors who bought the other 1000 shares is they all lost a lot of money, with no fundamental hope for recovery, while I laugh straight to the bank

Infamous Examples of Applied Pump and Dump Schemes

Jonathan Lebed

During the dot-com era, when stock market fever was at its height and many people spent significant amounts of time on stock Internet message boards, a 15-year-old named Jonathan Lebed showed how easy it was to use the Internet to run a successful pump and dump scheme. Lebed bought penny stocks and then promoted them on message boards, pointing at the price increase. When other investors bought the stock, Lebed sold his for a profit, leaving the other investors holding the bag.

He came to the attention of the U.S. Securities and Exchange Commission (SEC), which filed a civil suit against him alleging security manipulation. As is commonly the case in SEC actions, in what is an unjust, corrupt, and rigged game that's the world of finance, Lebed settled the charges by paying a fraction of his total gains. He neither admitted nor denied wrongdoing. In the end, Lebed got away with murder, and still ended up being a fifteen year old millionaire.

Currently there are rumors abound throughout the Internet that Jonathan Lebed is once again engaging in fraudulent penny stock manipulation under the banner of the National Inflation Association (N.I.A). This is backed by witness testimony from one of the company's founders; and evidence presented from e-mail newsletters misleading company members to invest in highly speculative penny stock that has a history of suspect volatility. However, no formal charges have yet to be delivered against the company.

Enron

Enron executives participated in an elaborate scheme of pump-and-dump in addition to other illegal practices that fooled the most experienced analysts on Wall Street. Studies of the anonymous messages posted on the Yahoo board dedicated to Enron revealed predictive messages that the company was basically a house of cards, and that investors should bail out while the stock was good. Enron had falsely reported profits which inflated the stock price, and then covered the real numbers by using questionable accounting practices. 29 Enron executives sold overvalued stock for more than a billion dollars before the company went bankrupt.


Pump and Dump: Awareness is Your Best Defense

As an investor, you must be vigilant of the pump and dump scheme. If history is any indication, you cannot depend on the law for protection. In addition, it's an unfortunate reality that with the invention of high speed Internet a pump and dump is now easier to pull off than ever before. The current depression will make pump and dump schemes much more prevalent and people will be vulnerable.

Of the gravest concern are villains exploiting the depression with misleading stock advice to clueless retail investors, who desperately need a place to park whatever little funds they have to protect their wealth from what will be either an inflation or deflation of the currency. One of the biggest scams I have personally noticed is the emergence of suspect stocks being advertised in mining companies and precious metal prospecting. These stocks are being sold as if they were actual physical gold, silver, palladium, or platinum. It's important to understand that usually such stocks are highly speculative and don't have near the reliability level as a real piece of gold and silver in the palm of your own hand.

A precious metal prospecting company is often the equivalent of buying a lottery ticket. Prospecting means just that, prospecting. The company doesn't have any gold, silver, platinum, etc. on hand. Their business model is to invest in finding precious metals. A very risky proposition, considering the said company is essentially investing into faith rather than on a product that could potentially be conceived by their own ingenuity. Indeed, they may find some silver, gold, etc. and you have just hit the jackpot, but in most cases rarely do people get this lucky. There's a reason why that stock is so cheap despite having a flashy word such as "gold" in front of it. Use your head; consider the timeless advice of if it's too good to be true, it probably is. . .

Another common scam I have noticed in the world of commodity investments are people dumping their hard earned money into what I call "phantom mines." A phantom mine is simply a mine that doesn't exist, yet is advertised as a sophisticated mining operation. One of my friends just recently fell for such a scam. Had he taken the time to make quick use of Google maps; and inserted the appropriate latitude and longitude coordinates of where the mining operation was apparently located, he would have seen nothing but a cattle ranch. Now maybe there's a secret underground gold mining operation in the basement of that cattle ranch, but somehow I doubt it.

It's important to note that even if the mine is real; that contrary to popular belief, investing in mining stocks isn't investing in precious metals. You're essentially investing in mining equipment, mining research, mining technology, and any ores the mine could hypothetically and potentially dig up. There is a fundamental difference between ore and bullion. In of itself, unrefined precious metal ore isn't very valuable. Most ore isn’t possible to refine in the first place, and until a solid bar of .999 gold or silver is actually produced, the real value of ore will always remain suspect. The mine makes money by selling the ores; the refinery on the other hand, makes money by actually producing the physical bullion bars.

So where do pump and dump schemes fit into precious metal prospecting and mining stocks? Simply put, these stocks are often highly speculative and are being advertised as a good alternative to what is the much more reliable physical storage of gold, silver, platinum, etc. As people's real incomes continue to dwindle, and the prices of commodities continue to raise, putting people further and further out of reach of precious metals proper; it's a given that people will exploit such a situation. In desperation, these retail investors who wish to invest in precious metals are incredibly vulnerable to pump and dump schemes. All the operator of the scheme needs to do is nest several hundred of his/her own shares in precious metal prospecting and mining stocks, and then mislead people priced out of the market that this is their opportunity to invest in precious metals. When the time is right, the operator pulls the trigger, leaving all the people he/she recommended the stock to in the dust.

-Donovan D. Westhaver

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