The ‘Pump and Dump’ Scams

17 Jan 2020  Read 684 Views

Have you ever received some extremely profitable market 'tip' about buying a particular stock? Maybe some other news about the 'next big investment'? All this at for nothing, absolutely free!

If you ever have received such a tip and you have yielded to it, unfortunately, you have been duped. If you have not seen any such tip, remember there is no free lunch in this world and no one will offer it to you as well. All these are part of a strategy called as 'Pump and Dump'; and such frauds are called as 'Pump and Dump Scams'

Movies like “Wolf of the Wall Street” are based on this. Jaspal Bhatti’s one of the most famous gig clearly explains this phenomenon in a hilarious way.

What influences a Share Price?

The market is full of speculators rather than informed investors. These speculating investors invest in any stock seeing the buzz around it. This is why stock markets are never perfect.

In an ideal scenario, the book value and market value of a share should be the same. Say we have a medium level company XYZ with share price ₹100. Now, someday there is some news that XYZ gets a new contract worth ₹100 crores. When people get to know this, they want to have a share in the growth of XYZ. The more XYZ grows, so grow its shareholders. Hence, people start offering a price that is more than ₹100.

Despite the fact that the current value of the share is ₹100, people anticipate that after this contract, XYZ will grow and the share value would rise to ₹125. Hence, investors would start offering a price higher than ₹100, say ₹120. Consequently, the share price of XYZ has reached ₹120 in no time, once the news reached to investors even before the company has started working on the contract!

Therefore, optimism for the future raises the prices, not the current state.

The Scam

As told, most investors in the market are speculators. Once some news starts making rounds, whether true or rumor, it influences investor sentiment. If the rumor were positive, people would want to buy the share. If it were negative, people would sell their shares.

In fact, just last year some promoters of Yes Bank were accused of deliberately spreading rumors to bring the share price down so that they may buy more of Yes Bank’s share from the market at a lower price and increase their holding.

The small-cap shares are even easy to manipulate. Not much information about them is available to people. Most of these are 'Penny Stocks.' Penny Stocks are dirt-cheap shares. The profit scope is huge with slight changes. Say there is a share of ₹1. You may buy 1 lakh such shares.
Even if the value jumps by just 5 paise that day, the profit value is ₹5000 in a single day. Wonder what would happen if it jumps to ₹2 in a matter of days! It is possible. It is easier for a stock to jump manifold when the value is small. You cannot expect a reasonably priced stock of ₹100 jumps to ₹200 in a matter of days, unlike penny stocks.

The Pump Phase

As explained above, the value of the stock increases on rumors. Say I own 1 lakh shares of PQR Inc. The company growth has been quite flat and I want to get rid of these shares. Assume the current price is ₹10 per share.

You would start getting SMS like “Multibagger Stock. Invest in PQR at ₹10. Buy 10000 shares. Target ₹15 in 2 weeks!” Unbelievable but true, such messages do the round. These messages look like genuine advice.
Some investors dream of such a huge profit. They start buying the shares. The value of shares starts rising.

The Dump Phase

This is the exit stage. When other investors start buying the share, its demand increases. The price starts increasing. The day it would reach ₹13, I would sell out all my shares and move out. The other investors might still be engaged with it, waiting for it to go higher. The share may rise for some more time, but it will start losing the steam when people start discovering the true value of the share.

My job is done and I don’t care about other investors. Someday people would realize that share is not worth the amount they paid! They paid me ₹13 for a share that was worth just ₹10. For 1 lakh shares, this value exceeds by ₹3 lakhs! Some investor has lost his ₹3 lakh because he overpaid. The company was not doing well that you would want to invest in its future. Yet people did because someone showed them a dream (it is not always politicians).

The Consequences

The ‘Pump and Dump’ is absolutely illegal.

SEBI and Courts can punish the one doing the ‘Pump and Dump’ if found guilty. No matter whether they are caught or they roam around scot-free, the investors have already lost their savings.

The Takeaways

In the current era of internet and WhatsApp misinformation, it has become tough to stay away from such tempting but frivolous proposals. However, one must not be a speculator. Whenever you plan to invest, always see what the company does, how it has fared so long, what are its plans, who are the promoters? Most of this information is available in the public domain and can be accessed through the internet.

Be realistic with expectations from Stock markets. From Warren Buffet to Rakesh Jhunjhunwala, no one has become a billionaire overnight. They have spent time and energy over-analyzing every move of every penny they spend on each share. Shortcuts take you nowhere. Prevention is Protection.

About the Author: Vivek Tiwari | 66 Post(s)

Vivek Tiwari is a Software Engineer and a Data Scientist who hopelessly fell for Economics. His plans to move to Management might now save mankind from his IITJEE selection story.

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