Whenever you read about penny stocks on websites that are not penny stocks-oriented, one of the first things they warn you about are pump and dump schemes. There is a very good reason for this and it is that penny stocks are definitely more commonly involved in such schemes than other stocks that are traded on more regulated markets. The good news is that penny stock pump and dump schemes are not that difficult to recognize and once you do that, you have a number of options as to what to do. But we will get to that later.
Why Penny Stocks?
There are a few reasons why penny stocks are more susceptible to pump and dump schemes. The first of these is the fact that penny stocks are traded on exchanges where the rules are more lax and where regulations are not as tight as on more traditional stock exchanges. Furthermore, it is much easier to produce hype surrounding a company that is a virtual unknown and which is out of public's eye. Finally, due to huge differences between the starting positions and the "dump" position, it is possible to make serious money with such schemes involving penny stocks.
It should be noted, however, that the penny stocks are not the only stocks that are involved in such schemes. These schemes are a scourge on any new market. For example, pumping and dumping was popular in Japan in the 1980s and it is currently rampant on Chinese stock exchanges, such as Beijing and Shenzhen.
How do Pump and Dump Schemes Work?
Pump and dump schemes are actually extremely simple, both in theory and in practice. Those involved in the scheme purchase a large number of penny stocks of a certain company and then they start increasing the value of this company artificially. This is the "pumping" part of the scheme. The company's stock value rises, the schemers' stocks increase in value and once the value reaches a certain point, they sell their stocks at a massive profit. This is the "dumping" part of the scheme. People who buy their stocks once the price has already been pumped find themselves owning stocks that are worth nothing while those who pumped and dumped score massive gains.
Signs of a Pump and Dump Scheme
The first sign that a penny stock might be involved in a pump and dump scheme is that its value is skyrocketing at a previously unprecedented rate. Not all penny stocks that start rising in value quickly are pump and dump schemes. Those that are not, however, will be involved in important news that will affect their price. For example, if a startup has come up with a service or a product that is revolutionizing a certain industry and the media have caught wind of it, it is not a wonder that their penny stocks are getting crazy.
However, if there is a lack of objective news and media coverage, it is likely that you are looking at a pump and dump scheme. Another sign that a penny stock might be "pumped" is the avalanche of emails, various new websites popping up and traditional mail arriving at your door, all saying how this new stock is the best thing since sliced bread. Timothy Sykes, one of the most successful penny stock traders ever, always emphasizes the need to be extremely careful about where you get your info on penny stocks, especially when we are talking picking those to invest in.
Furthermore, when you look at the company's financial reports, you will see that everything is not right. Financial reports are extremely difficult to forge and they are perhaps the best way to check a penny stock. If the company has enormous outstanding debts, no recent income and other liabilities while its stock price is rising, it is more likely than not that this is a pump and dump scheme. Finally, if you notice an extremely irregular jump in trade volume, you are probably looking at a pump and dump. For instance, company's stocks haven't been traded in months or even years and then, in matter of days, most of their stocks have changed hands. This is another red flag.
It is important to keep in mind, however, that not all of these signs are indication that an increase in value is definitely because of a pump and dump scheme. However, if you find out that all of these are present, the chances are high that you are in presence of a pump and dump scheme.
Shorting the Pump and Dump Schemes
Shorting is a practice that some people use to make money from pump and dump schemes. These are people who are not doing the pumping and dumping themselves, but who recognize that something like that is going down. They "get in on it", so to say, purchasing the stocks while they are on the upwards trajectory and then selling them before the dumping starts. In essence, they are doing the same as those who pump and dump, only without being able to actually control when the dumping begins.
If you are interested in doing it, you should know that shorting on a pump and dump scheme is a very risky business as you can never be sure when the dumping is going to begin and you might find yourself with a portfolio filled with worthless stocks. Also, you would need to get in on it very, very early to make any sort of major profit.
That being said, many experts claim that shorting on penny stock pump and dump schemes is a good idea. However, it is definitely not something you should do without learning everything beforehand and without being certain that you will know how to pull it off.
AUTHOR: James D. Burbank is the editor-in-chief of BizzMarkBlog, a blog all about business and finances. He is also a huge NBA fan.