Alton Hill is a Cofounder at TradingSim. He has a passion to help people and found that one of his ways of doing so, is through the world of Day Trading. Alton’s skillset is in Product Development and Design Thinking which he uses to write and improve the overall experience for TradingSim.
Pump and dump stocks make me sick and just to be clear I do not trade these setups.
When I look at a stock chart I normally see bulls and bears battling to see who will come out on top.
However, when I look at a pump and dump stock it just saddens me. For those of you that watched the show Spartacus, it’s like when Gladiators have to fight outside of the arena and in dark alleys.
As I see the sharp incline up and subsequent collapse, I think of all the poor souls that have lost IRA accounts, college savings and down payments for their homes.
Well in this article, I’m going to cover 2 ways you can profit from these setups and clues a pump and dump scenario is taking place.
Before we hit the two strategies, let’s first ground ourselves on the background of pump and dump stocks.
Table of Contents
What is a Pump and Dump Stock?
These are stocks that shoot up like a rocket in a short period of time, only to crash down just as quickly shortly thereafter. The stocks often come out of nowhere and then the buzz on them reaches a feverish pitch.
We can break the pump and dump down into three phases.
Pump and Dump Phases
Phase 1 – The Markup
Every phase of the pump and dump scheme are challenging, but phase one is really tricky. The ring of thieves need to come up with an entire plan of attack to drum up excitement for the security but more importantly people pulling out their own cash.
The scheme can be as simple as releasing a fake news report. Or it can be as complex as a coordinated effort of press releases, fraudulent case studies and TV coverage.
The more elaborate the scheme and the better the execution, the greater the reach.
The goal of the markup is to get as many public investors as possible heavily invested in the shortest amount of time.
Remember, the scheme can’t work if it takes a year to get the stock up because someone is going to call BS on all the claims of greatness.
Phase 2 – Distribution
This sounds simple, but this too takes some skill. The fraudulent investors now need to find a way to sell off their stake without causing too much shock in the stock. This way they can command the most value for their shares and walk away with the most money possible.
The illegal participants will need to time their sell transaction just right and likely on a morning gap higher as the stock explodes higher.
Phase 3 – The Crash
I was trying to think of how best to describe the selloff but it’s honestly nothing short of a crash. The stock just falls like a rock.
This is where the panic begins to sink in for all of the retail investors that either lost paper fortunes or their dreams of the million-dollar trade erased.
Ways you can Profit (Not Recommended)
Why discuss something that I do not recommend? Well I know people are going to chase the money regardless of how much I state to avoid these setups. So, I have to provide a response of ways you can protect yourself if you decide to dip your pinky toe into the water.
Now that you understand the three phases of the pump and dump scheme, let’s drill into the two ways you can profit from the pattern.
You might be thinking, why profit from the hurt and pain inflicted on traders? This is a great question that will touch upon your morality.
For me, I don’t trade these stocks because the risk is too great and again I have found other ways to make money in the market.
Method 1 – Long the Run Up
Quick Run-Ups (Penny Stocks)
The key for going long the run-up is getting in early enough to avoid the selloff, but not too early and your money sits in a stock that only moves up 20% for a few days to then collapse.
The trick is you have to search social media and stock forums for over the counter stocks to see which ones have the most hype.
Next, you want the stock to move significantly with volume. This means a gain of 30% or more in one day.
You don’t want to start buying into a penny stock because it’s up 10%. That sort of increase is likely an everyday event.
Once you have validated that the stock is being actively tracked by traders and has had a 30% or more one day run. Look to buy in on the next day on a break of the first day’s highs.
Here comes the hardest part of the long trade – you have to be prepared to sell your position. Remember you cannot wed the stock as you know doom and gloom are right around the corner.
To this point, the rallies will often last three to 5 days – that’s it.
So, you will want to keep a close eye on the number of days the stock is rallying and know that you will never get it at its peak.
To do that, you would need to be one of the conspirators defrauding people out of their money.
These are the Enron’s of the world which takes years for the selloff to take place.
In this scenario, I would avoid trying to buy the run-up. One you will not know it’s a penny stock because large corporations may take years to be exposed, so there is no way you can know you are buying during the markup phase.
Another example of a more recent pump and dump scheme on a large scale is Theranos. Theranos is a company that provides cutting-edge medical testing capabilities and it was just discovered the prior CEO Elizabeth Holmes may have exaggerated positive claims of testing results to drum up more money from investors.
To get an idea of how much money is currently in question, take a look at the below table:
Theranos Funding Rounds
Now do not interpret this to mean Theranos is worthless. There is value in the company, just likely not at the prior valuations made by investors.
The point of highlighting Theranos is to show you that the ability to scam investors can happen at all levels and even those deemed the most sophisticated can be “got”.
These large-scale manipulations will again take years to prove, so it’s best you focus your energy on identifying the penny stock setups because your money will be returned much quicker
Method 2 – Short the Selloff
Shorting the selloff is the quickest money you will ever make, but also requires the most skill. You have to be able to find a point where the stock is starting to break but also simultaneously not get on your high horse that the stock is worthless in the event the scheme kicks into second gear and you shorted too soon.
Oh man oh man, the emotional sways that can occur in such a scenario.
Sounds simple right; well it’s anything but that because you need to time the selloff almost to the day.
How to Find Pump and Dump Stocks
Where to Find Pump and Dump Stocks
Pump and dump stocks mostly live on the over-the-counter bulletin (OTCBB). These are stocks under 5 dollars with less transparency into their financial health.
This does not mean you are risk-free from a pump and dump move if you trade stocks on the Nasdaq. It just means it will take a more sophisticated con person to pull it off.
In order to find pump and dump stocks, you need to go to the dark alleys of the web.
What I mean by this is you are not going to see coverage of OTC penny stocks making moves on 50k shares as a news report on Forbes.com.
You need to find as many penny stock message boards and penny stock alert services you can get your hands on.
You also need to live on stocktwits and see which low float penny stocks are trending as well as having a price surge.
Between the forums, email alert services and stocktwits you will have a great feel for what crappy stocks are in play. If you think I’m exaggerating about what goes on around the web take a look at these two white papers published by the SEC which cover Investor Alerts and Internet Fraud.
Pump and Dump Chart Examples
Now to be clear, every time a stock has a sharp rise and a decline does not mean something fraudulent occurred. Trader emotions can also create mass hysteria.
The below examples are to only give you a visual representation of what a pump and dump chart looks like, but does not mean the companies mentioned performed any illegal behavior that would violate rules and laws as dictated by the SEC.
Pump and Dump Example 1
Pump and Dump Example 2
Is Pump and Dump Illegal?
If you are trading the momentum of a stock both long and short, you are not committing any crime. You are just trading the stock of the day, which happens to be an extremely volatile penny stock.
However, if you are knowingly attempting to manipulate the value of a stock in order to profit and leave investors holding the bag, you run the risk of going to prison.
Now as we mentioned earlier in this article, your morality is a personal decision that you will need to sort through.
But believe that there are pump and dump schemes executed and no one is ever caught.
Pump and Dump Schemes
A wildly documented example of penny stock manipulation scheme is from a few years ago with the site awesomepennystocks.com run by John Babikian (Wolf of Montreal).
Babikian reportedly made over 100 million dollars in the scheme. He would acquire a large number of shares in a penny stock company and then conduct massive promotions of the stock via multiple web sites.
Once the stock made their run, Babikian would sell his stake and reap the profits.
Well it all came to a head once both Canadian officials and the FBI began to investigate the activity on the site and the reported significant gains.
The conflict in the numbers became overly apparent when Babikian’s wife filed for divorce claiming he had made millions of dollars while only reporting $47,677 in income over a three-year period.
Check out this article from the Street which details the scheme and how the stocks would rally once the email promotion started, only to recede to even lower levels once the email hype ceased.
So, whatever happened to John? He is currently living in Russia with an estimated net worth according to Wikipedia of $250 million.
Pump and Dump Marks
As I was writing this article, it occurred to me that pump and dump stocks create too much emotions.
With the potential of stocks rising 1,000+% to 10,000% in days, even if you know the stock is a dud, the greed maybe too great to pass up the opportunity. I know that sounds crazy, but this is essentially a form of gambling and not investing.
So, if you find yourself in any of the buckets listed in this infographic, you honestly should not try to profit from pump and dump stocks, because you could become a likely victim.
Pump and Dump Marks
Pump and Dump and Cryptocurrencies
This is all the craze these days – the high level of potential market manipulation with cryptocurrencies. To be honest with you, I don’t think anyone has a good handle on what is going on with cryptocurrencies and how they are trading.
The U.S. Commodity Futures Trading Commission has put out message after message warning investors of the risks of cryptocurrency investing and to not purchase any cryptocurrency based on “social media tips or sudden prices spikes.”
But how does one hear that message when you see charts like the one below?
Bitcoin long-term chart
While the run-up in bitcoin for example has been unprecedented, I would hesitate to categorize cryptocurrency as a pump and dump scenario.
Blockchain (the engine behind cryptocurrencies) is very real and the applications go beyond one industry. There are advancements taking place in banking and health care all with the infrastructure provided by block chain which also backs cryptocurrency.
So, the technology and the vision are real, there is no denying that.
Also, cryptocurrencies expand the financial system to areas of the world that desperately need it, thus expanding the resources typically enjoyed by G7 nations.
The one area you will need to avoid when it comes to cryptocurrencies are the very small illiquid currencies offered at .01 cents etc.
You will want to stick with high volume cryptocurrencies like Bitcoin, EOS and Ethereum.
Pump and dump scams are vicious, cruel and illegal. If you are determined to trade these setups you need to paper trade them for an extended period of time to make sure your strategy is solid on Tradingsim. You will also want to consider signing up for services like Timothy Sykes who specializes in penny stock trading.
Remember to exercise extreme caution and trading is a marathon and not a sprint.