Pump and dump is a situation in which the price of a stock, which has been bought cheaply, rises due to fraudulent information and is sold for a profit, causing others to lose their investments.
Therefore, we are facing a situation artificially and misleadingly caused to obtain a benefit at the expense of the losses of others. Thus, it can be translated as “inflate and undo” and the speculator acts on the market with the aim of causing price increases.
In this way, the end itself is not to make others lose money. In fact, the raison d’être is for that speculator to make money on the trade. The problem is that when he sells his share, it causes price drops and losses for other investors.
Pump and dump step by step
Let’s see how this investment fraud can be carried out. Keep in mind that, although there are multiple variants, the steps are essentially the same.
- The investor who wants to carry out a pump and dump buys shares whose market price is very low.
- Through its institutional, digital, personal, economic or any other type of influence, it manages to make people believe that these actions are a good investment.
- Then the small investor also buys and this generates a rise in prices by increasing the demand for this financial asset.
- The originator then sells and collects his profits due to this markup. Not so the rest who see how they are not able to get rid of their investment if it is not at a loss.
The difficulty of regulating the pump and dump
This type of fraudulent action ends up taking its toll on the entire society. In the end, many people end up going bankrupt and this affects the economy of the country where the pump and dump takes place. Therefore, it is very far from economic or market freedom.
For this reason, most countries in the world have ended up legislating against these practices. As an example, we have the US, which has regulated the market for “penny stocks”, shares of very low value and quality. In this way, the investor knows the risk that he runs by investing in them.
However, there are experts who consider it difficult to prove fraudulent intent. And there is the main stumbling block to legislate. For this reason, some measures that are taken do not go through the regulation itself, but because the expert who advises has a certification that accredits him.
Pump and dump example: GameStop
Let’s see, finally, a real example of this type of fraud. This is a case that was an exceptional phenomenon on Wall Street (WS). This is a US chain store that sells electronics, GameStop.
An essential actor in this matter was Reddit, a social network similar to Facebook or Twitter. Within it would be “Wall Street bets” which would be a forum on where to invest in WS. Well, now we have all the necessary elements.
The process is simple, the “star” investor took advantage of GameStop’s bad situation to buy shares of the company very cheaply. Thanks to Reddit, the idea that it was a good business spread and many invested.
The pump and dump process did the rest. Stocks rose, but fraudulently. Many jumped into buying “misadvised” and when the sell-off occurred, they could no longer do so. They ended up losing their money.