Wednesday, 5 September, 2007

Pump and Dump?

Most of you must have heard this phrase, Pump and Dump. What exactly does it mean and how can one protect their investments and avoid such scams in the stock market.

Pump & Dump

Pump and Dump, as the words suggest mean someone actually pumping something and then eventually dumping. As the saying goes, a picture is better than 1000 words, i will take examples with charts below that will make this terminology perfectly clear.

In short, if a stock moves up very fast on extremely high volume and then comes down on low volume, AND is unable to move back up again. It is termed as Pump and Dump. Why? Mostly because such stocks create a buzz around in the market when they are moving up which increases the trading activity in the stock and hence the volume. Since most stocks have very small floats, any increase in volatility increases the stock prices by folds. Alas, such stocks cannot continue with their upward trend because they do not have any underlying Fundamentals to support them.

What Stocks are more vulnerable to Pump & Dump

More than 95% of the time, only penny stocks are affected by Pump and Dump. Why? Because it is extremely easy to generate interest, create a buzz, sell at the top and get away without any real legal issues. Add to it the small float/outstanding shares and it tells you the story. It is not surprising for a group of 10-50 people controlling a huge %age of a Penny stock and hence move it up and down at their own will. However, such actions cannot happen with well known companies or stocks that are trading at relatively higher prices.

Example of Pump & Dump

Though there are many such cases, i just picked Maximaa systems ltd randomly. Take a look at the chart (By the way i got many requests for chart to be made inline. However, since all the charts that i post are huge, they cannot be made inline. Charts should be large and clear to make any sense and not all times they can fit into these articles)
Let me narrate using timeframes.

Until early May 2007, the stock had barely any volume and interest in it and it was just cruising along to the upside. However, if you notice, in early May, there was a huge spike in volume and the stock just kept moving up after that. Within just less than a month the stock made a whopping 100% gain. However, all along while the stock was making new highs, the volumes just kept eroding.

Coming back to Today, the stock is more or less at the same place where it started to move up. And what ever happened to the volume?

A perfect example of how the stock was pumped up and up and then dumped. There is hardly any interest in the stock now.

The sad part of this story. Common investor would have been pulled into the stock around late May. Unless they sold their positions off using Swing Trading within a few day(s) or week(s), they would be stuck holding to a stock with a loss of over 70%.

Compare Pump & Dump story with a Reliable Stock

Now let us see how a more stable and Non-penny stock behaved in the same course of life. I could have once again compared any stock, but i just chose Reliance randomly. Take a look at this chart now.

Early June, if a common investor had gotten into Reliance/Maximaa, they would be at 50% profit and over 75% loss respectively. This is the major difference between going for a Penny verses non-penny stock.

So, what should i do?

Trading penny stocks is fine. However, penny stocks are usually not for the long term as they are extremely vulnerable to foul play and manipulations. Stay away from it unless you are a day or swing trader and/or have been trading for a while to understand the semantics of such stock moves.