If you’re going to invest in penny stocks, you need to know how to spot a pump-and-dump scheme.
This is the devious practice of insiders promoting a stock — manipulating its price higher through short-term hype (“pump”) — and then selling out themselves at the top (“dump”), leaving those who bought on the ascent with huge losses as the stock crashes.
These amoral shareholders can use all sorts of trickery and deception to dupe the investing public into buying the penny stocks they want to cash in on.
[See: 10 of the Best Cheap Stocks to Buy Under $10.]
Here are five surefire signs that can alert you to a pump-and-dump scheme as it’s happening.
If you get emailed about a penny stock, or reached out to in any way, it’s probably a pump-and-dump scheme. Sometimes, market-watchers and investors may receive emails promoting a certain penny stock. It’s pretty much never a good idea to follow this advice.
This is a favorite method of the pump-and-dump scam artist. It’s not just e-mails, though, and it’s not always the pumpers themselves that end up reaching out. Oftentimes the scammers hire promoters to get the word out.
“Getting the same tip from multiple sources at once, usually via social media or unsolicited e-mails, signals the full-on pump phase,” says Darren Fischer, head recruiter at Maverick Trading, a company dedicated to finding, training and funding good stock market traders.
If that penny stock is shooting higher at the same time, it’s definitely a pump-and-dump scheme. It’s a bit weird in the first place to get an email (forget multiple emails), phone call or social media blast telling you how awesome a particular penny stock is. But say you then decide to see how the stock’s doing, and it’s up 50 percent in the last three days.
Pat yourself on the back. You’ve almost certainly found a pump-and-dump scheme.
But how and why do scammers do this?
“For example, any two fraudsters can orchestrate a real trade at an unreal price so the actual trade price becomes a print on record,” says K.C. Ma, professor of finance at Stetson University. “And of course, we all love to trade on tips by buying in as the price is shooting up.”
Promise of guaranteed returns — goes for pretty much anything. Markets with little regulation is where manipulation is most prone to happening, and where absurd guarantees are most likely to be found. The same schemes play out again and again, from the world of penny stocks to the cryptocurrency market.
[Read: 3 Important Things to Know About Bitcoin.]
One theme is often present consistently across schemes and scams.
“Hints or promises of high returns, with little or no risk, are classic warning signs of fraud,” says the Financial Industry Regulatory Authority (FINRA) on its website. It’s one of three penny stock warning signs FINRA lists on its website.
If there’s a broker or brokerage firm selling penny stocks that isn’t registered. Oftentimes, there isn’t anyone even close to resembling a broker trying to get you in on the penny stock in question. But sometimes there is, and that can be part of the allure that makes the opportunity seem legitimate.
“If the firm or individual is not registered, or if a registered firm or individual is trying to sell you an unregistered penny stock, contact FINRA,” the agency says.
Legally, people (and firms) aren’t allowed to give investment advice or sell securities without certain licenses and registrations. You can check by using FINRA’s BrokerCheck website to search for the party in question.
Sudden increase in volume. Most penny stocks are pretty illiquid. So if there’s been no trading in this stock in days, weeks or months, but suddenly there’s tens of thousands of shares trading hands, perhaps for multiple days in a row, this is a red flag.
A “significant spike in volume and price on a chart that occurs immediately prior to you getting the tip on the stock” is a dead giveaway that there’s a pump-and-dump scheme going on, Fischer says.
This sign is particularly notable when the price chart has been flat, with little to no volume for days, weeks or months before the jump.
Other warning signs. Those are the five strongest indicators that something is terribly wrong, but there can be others. For example:
— Unregistered stocks. Just like your broker has to be registered by FINRA, for a company to be considered generally investable, it should be registered with the Securities and Exchange Commission. That requires the company to file periodic financial statements. Use the SEC’s EDGAR database online to check for filings from the company.
— Absurd bid-ask spread. This is an oft-forgotten issue that can absolutely murder your returns. Typically a result of low liquidity, it means that in order to buy into the stock you’ve got to pay a much higher price than you can immediately turn around and sell it for. In liquid, blue-chip stocks this spread is miniscule. Not in penny stocks.
— Inception of company before Dodd-Frank regulations. Before this 2010 post-crisis regulation, companies could more easily be set up as shells, get listed on over-the-counter markets and be used to defraud investors.
While this list may not be completely comprehensive, it should give you a pretty good idea about how to avoid getting duped in a pump-and-dump scheme — in penny stocks or another arena of investing.
[See: 7 of the Best Stocks to Buy for 2018.]
Ultimately, there are many more land mines to avoid than in more established names, but if you’re going to play penny stocks, it’s usually best to never use more than 1 to 2 percent of your investing assets.
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Penny Stocks: 5 Ways to Spot a Pump-and-Dump Scam originally appeared on usnews.com
