"The more I find out, the less I know."

Tuesday - December 28, 2004 at 12:26 PM in

Making money from Pump & Dump

If you have a fax machine or E-mail inbox, you've probably seen these:

Fly-By-Night (OTC:BB FLYB) is about to QUADRUPLE in price as investors discover this hidden gem!

And so forth....

This is the classic "pump-and-dump" stock fraud, where the fraudsters quietly load up on the stock in advance, then promote the crap out of it, hoping to drive the price higher to make a quick profit. The company itself may have nothing to do with the promoters, but just happens to be a convenient target.
Investors are well-advised to ignore these stock touts. In many cases the company itself is nearly worthless, and the price is likely to collapse as soon as the hypesters have sold their stock and stop promoting it.

But the capitalist part of me keeps thinking....isn't there some way to make money off these schemes?

In theory, a typical stock being pumped-and-dumped should follow a specific and predictable pattern: first, it gradually goes up in price as the perpetrators accumulate stock on the open market (this phase may be skipped if the scam artists are insiders or have some other way of acquiring the stock without buying it on the market). In this first phase, there's no way for an outsider to know the stock will soon be hyped.

Next, the perpetrators begin promoting the stock through spam, chat rooms, telemarketing, junk fax, etc. Since the stock has (presumably) been chosen because it doesn't trade much and will move a lot when people start to buy or sell it, this promotion should drive the stock price up. As the stock goes up, other investors may take note and buy, driving the price up more.

The third phase is when the scam artists start selling their stock, presumably after it has hit a price where they can make a profit on their scheme. They keep promoting the stock, since it has to stay high long enough to sell all or most of their shares.

Finally, once the fraudsters have cashed out, they stop promoting the stock. Without the hype, there are few (if any) new buyers, and the people who bought the stock find that they have nobody to sell to. The price crashes.

It is impossible to identify a pump-and-dump scheme in the first phase, but once it starts getting promoted it may be hard to miss. In principle, there are two ways to make money once the stock is being pumped. First by buying before the peak and selling ahead of the promoters, and second by selling the stock short at almost any time after it has appreciated. Both approaches have potential, but also significant risks.

Buying the stock before the peak puts you in the position of trying to figure out when the scammers will stop promoting the stock and let the price crash. You are inherently at a disadvantage, since the scammers are making the decision. If you make a wrong move, you could be out your entire investment.

Shorting the stock is, in principle, simpler. If you short the stock, you are betting that the price will fall, and you know that it has to fall when the scammers stop promoting it. In practice, it isn't so simple. Many of the stocks promoted in pump-and-dump schemes cannot be sold short because they are too thinly traded. Even if the stock can be shorted, short sales carry some unique risks: a short sale has (in theory) the potential for unlimited loss; and there's the risk that your broker might force you to buy back (cover) the stock before it falls.

All these ideas for profiting from pump-and-dump implicitly assume that the market for the target stock is reasonably well functioning (unlike, for example, this scheme where the mob set up its own brokerage and threatened people with knives if they tried to sell). Unfortunately, the scam artists intentionally choose companies where the stock trades very infrequently--these are the stocks which are easiest to manipulate. If short sales aren't possible (and they probably won't be), then the only way to profit is by getting in and out before the scammers. Sounds like a losing game to me.

So....on to my next great money-making idea....

Posted at 12:26 PM | Permalink | | |

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