Summary: In this guide, we explain what a pump and dump scheme is, how it works, and how it affects the stock market and the crypto space. We also go through some basic tips on how to identify pump and dump activity and how to avoid it.
What is a pump and dump scheme?
Fraudsters use pump and dump schemes to create a buying frenzy that aims to “pump” the price of a stock or cryptocurrency and then “dump” the shares of the stock or crypto by selling them at an inflated price. After making profits, fraudsters stop the hype, and the price of the stock or crypto falls, causing investors to lose money.
Spreading false or misleading information about a crypto token can occur through various channels, including social media, investment newsletters, investment research websites, emails, online advertisements, internet chat rooms, newspapers, cold calling, and fake news releases, among others.
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How does a pump and dump scheme work?
Pump and dump schemes are common among penny stocks, also known as microcap stocks. These stocks belong to companies with small market capitalization and are usually traded over-the-counter (OTC) at low prices. They don’t usually follow strict requirements for public listing.
This makes it easier for fraudsters to manipulate and spread information about these securities. Limited public information creates extra favorable conditions for fraudsters since potential investors have limited sources to verify all information about a stock or token and the company it comes from.
Additionally, microcap stocks are illiquid securities that have extremely low trading volumes. Therefore, even relatively smaller transactions can inflate the security price significantly.
The basics of a pump and dump activity
Traditionally, fraudsters involved in pump and dump schemes used cold calling to woo investors. Today, the presence of the internet has made most of the activity shift online. Fraudsters often use hundreds or thousands of email messages and other enticing messages to attract investors to buy a particular stock or crypto quickly.
Usually, the messages claim to have inside information about a particular oncoming development that could trigger a major hike in the share price. With limited sources to verify the truth behind the information and the project, buyers often jump in, as the stock price increases significantly.
After many buyers have jumped in and the price has increased significantly, the initiators of the pump and dump scheme sell their shares, and due to a substantial sales volume, the stock price drops dramatically. In the end, many investors incur huge losses.
Additionally, pump and dump schemes may be perpetrated by anybody with an online account and the capacity to convince investors to buy a stock. Such perpetrators can fuel their actions by buying heavily into a stock trading on low volume, eventually pumping up the price.
Pump and dump schemes in crypto
With cryptocurrencies, two types of pump and dump schemes are most prevalent.
- In the first type, insiders promote a particular token and stir up all the hype, while on the backside, they sell it slowly. By the time other holders realize that something strange is happening, the fraudsters will have made profits, and the token price drops;
- The second type targets cryptocurrency while using community members of a particular cryptocurrency or holders to buy it. This action triggers robots used by fraudsters to buy too while the perpetrators keep selling at inflated prices. In the end, the price drops and some members end up losing money.
The first instance of a pump and dump scheme can happen in any token. However, the second scheme works with smaller and less popular cryptocurrencies, whose prices are easier to pump up.
The cryptocurrency field has become more attractive to pump-and-dump schemes because of the lack of regulation in the crypto market and the technical complexity of crypto assets.
According to a 2018 study, which investigated the prevalence of pump-and-dump schemes in the cryptocurrency market, researchers discovered over 3,400 such schemes within a period of six months while observing two group-messaging platforms linked to cryptocurrency investment.
These coins are believed to have turned out to be scams, lacked funding, or failed due to other reasons that rendered the unviable or inactive.
Crypto pump and dump chain
Large pump and dump crypto groups employ a complicated structure consisting of the following layers:
- Inner circle;
- Outer rim;
- Rank-and-file pumpers.
Usually, organizers and some individuals from the inner circle take charge of the whole process. They decide what type of cryptocurrency or token they want to work with and how they want to promote the asset. Besides, they also choose the timing. Organizers and insiders of a pump-and-dump scheme often take the lion’s share of the profits obtained from the scheme if everything goes as planned.
Members of the inner circle discover what cryptocurrency they are going to dump just shortly after the decision by the organizers. Other community members, including the outer rim and last-minute pumpers, discover all the details much later, after most of the move has already taken place, making it difficult for last-minute pumpers to benefit hugely from the scheme.
The phases of the crypto pump and dump schemes
Crypto pump and dump schemes consist of two major phases, namely the “pump” and the “dump.”
1. The “pump” phase
In some instances, the fraudsters accompany their messages with memes of rocket ships going to the moon and different cryptocurrencies illustrated on them. This action lures more investors to jump in and buy. In the meantime, the scheme’s perpetrators already hold a substantial amount of the coins available.
2. The “dump” phase
How to identify a pump and dump scheme?
There is no single rule for identifying whether a cryptocurrency or token is being used in a pump-and-dump scheme. Investors need to research and apply their best judgment when deciding to take a chance on a token or coin. However, the following indicators often serve as red flags:
- Major hype
Excessive hype around a particular coin or project could be a solid indication of a pump-and-dump activity. Bulk marketing e-mails and social media posts with alluring messages such as “this coin is the next big thing” or “Bitcoin 2.0 is here” followed by quick price rallies could signify a pump and dump.
When there’s unusual optimism around a cryptocurrency or token for no valid reason, it might raise a red flag. In that case, potential investors should investigate further.
- A token or crypto price spike
All pump and dump schemes are characterized by a sharp rise in price within a short period. This can happen to any coin, but it usually targets previously unknown, ignored, or forgotten coins.
- Publicity cycle
This follows the hype and “news” about a particular coin or project, which often coincide with the purchases done by insiders. It creates an illusion that something big is happening, and this publicity cycle draws more potential buyers to jump in to see what’s happening. This drives prices up even further until the bubble breaks.
Types of pump and dump schemes
Pump and dump schemes occur in different forms, including the following:
- Classic pump and dump scheme
This type of pump-and-dump scheme involves any type of manipulation of information about a company and its stock, token, or coin. The perpetrators use the telephone, fake news releases, as well as distribution of some kind of “inside” information that can help drive the stock or token price. Additionally, some dishonest promoters may jump in with false information to lure investors to the project.
- Boiler room
The boiler room is a term used to refer to a small brokerage firm with some brokers that use dishonest sales practices to sell questionable products to investors. The brokers often use cold calling to sell micro-cap stocks from the firm, aiming to sell as many stocks as possible to boost the price of the stocks. Once the stock price increases significantly, the firm sells its shares of the stock for huge profits.
- “Wrong number” pump and dump scheme
This type of pump and dump scheme is where fraudsters use short text messages (SMS) and voicemails laced with “hot” investment tips to lure their targets to believe that it was accidentally left on the recipient’s phone. However, it’s a calculated move to attract the attention of potential investors to a particular stock, coin, or token, thereby boosting demand.
Four tips to avoid pump and dump schemes
Pump and dump schemes are common in the crypto space and can strike at any time. Here are some tips to help investors avoid becoming a victim, as advised by the Securities and Exchange Commission:
#1 Be wary of unsolicited investment offers
Investors need to exercise extreme caution if they receive any unsolicited communication about an “investment opportunity.” With multiple avenues for virtual communication, such messages can reach investors in several ways, including emails, comments, or posts on social media pages.
#2 Watch out for obvious red flags
As an investor, here is where you need to trust your instincts. The so-called investments may sound too good to be true, promise huge “guaranteed” returns, and come with the pressure to “buy now.” All these are common red flags for pump-and-dump perpetrators.
#3 Do your own research and due diligence
Before investing in any high-yielding project, investors need to conduct their own research and due diligence. They can utilize reliable sources of information online to learn about companies, business prospects, management, and financial statements. Additionally, they can get reviews from third-party websites to get a grasp of what others are saying about the project in question. Any company or digital asset that lacks this information can be seen as a red flag.
#4 Reflect on the source of the hype
Pump-and-dump schemes rely on hype and an increased sense of urgency. The hype is often from a third party, which may be through a newsletter or social media account. If you don’t trust the source of the information, it may be part of a scam activity.
Additionally, investors should be wary of “hot tips” often promoted by pump-and-dump schemers. They often survive on an amplified sense of urgency and fear of missing out (FOMO), which drives many potential investors to jump in without verifying the truth behind a project.
Are pump and dump schemes illegal?
Pump and dump schemes are considered illegal under various laws and acts because the activity involves manipulating securities prices through misleading information. For example, the Securities Act of 1933 and the Securities Exchange Act of 1934 both provide segments that criminalize misleading statements and frauds associated with securities.
The regulatory body has even charged pump-and-dump offenders to ensure that the investment field is safe for innocent investors who are often the subject of price manipulation.
The bottom line
Crypto pump and dump projects are just some of the challenges that investors have to grapple with in the crypto space and stock market. With the proper information available in this guide and other sources, investors can know how to separate hype from facts and choose viable investment opportunities.
Several altcoins have been victims of pump and dump schemes, and while such schemes are unpredictable, the red flags mentioned in this guide could help avoid falling into their traps.
Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.
FAQs on the crypto pump and dump
What is a pump and dump scheme?
A crypto pump and dump scheme is a process where fraudsters spread false information about a coin or a token to inflate its price and then sell their shares to make profits as other investors make losses.
Is a pump and dump scheme illegal?
Pump and dump schemes are considered illegal under several laws, including the Securities Act of 1933 and the Securities Exchange Act of 1934. This is because it leads to heavy financial losses among innocent investors. Regulatory bodies are keen on any instances of price manipulation and ready to penalize the perpetrators.
How can I avoid a crypto pump and dump trap?
Pump and dump activities are unpredictable, but there are red flags to watch for. Always do your research and due diligence about any project before investing. Always verify the source of the information you get online and avoid questionable investment offers.
How do I know if it’s a pump-and-dump scheme?
Pump-and-dump schemes often involve an influx of e-mails, social media hypes, cold calls, and other methods of messaging meant to lure investors into such projects. They target micro-cap stocks or little-known cryptocurrencies or tokens, urging people to invest immediately to reap huge profits.