What to watch for to avoid infamous pump and dumps
A pump and dump is a fairly simple concept. Large groups of individual traders buy many shares of a volatile stock and “pump” it up with consistent buy volume. Then, just when you think the security is breaking through all levels of resistance and can’t be stopped, there is a huge sell off of all previously bought shares. This not only creates a trap for new investors, but also cancels out any past gains that the security may have had.
Most investors think that they are immune to a pump and dump scam, but it actually happens to almost every investor. At times, you might be a part of the pump and not even realize it! For example, if you hear about a security from a buddy on social media, there’s a good chance that they’re just trying to increase the price per share (PPS) on his or her pump and dump.
One simple way to spot a pump and dump is volume.
As you can see, it is very easy to spot the volume spike, and of course, the dump. This stock was pumped up multiple times only to fall under it’s 52-week lows.
Since this is post-pump, the chart is easily recognized. But, how do you recognize the pump beforehand? It’s simple. You must calculate the stocks valuation by analyzing its assets, liabilities, and overall PPS. That way, if you see that a stock has had a dramatic increase in PPS, you can justify the increase.
Another thing you must do is spot the catalyst. If there is a lack of a catalyst or the catalyst doesn't justify a large increase, then the price jump is not sustainable. For example, if the catalyst is a share repurchasing from the company, and the stock's PPS increases 60%, use your common sense. Is there a catalyst? Yes. Is the share repurchasing enough justification for a 60% increase? No. Therefore, it is most likely a pump and dump.
All in all, an uncalled for volume spike, an insufficient valuation, and a lack of a catalyst are all red flags. So be aware, be careful, and don’t throw your money away! If you wanted a lottery ticket, you could just walk to the gas station and buy one. Otherwise, do your due diligence and stick to wise investments.