When I was working as an administrative assistant, I periodically got faxes with “hot” stock tips. They were cleverly addressed to someone else (with hand-written notes), as though perhaps the number had been misdialed. Like buzz marketing, it gives us the impression that we’re getting the facts from people in the know.

Of course, it was actually just spam targeting people who think they’re getting in on something good. I always chucked them, but since I’m interested in PF I did take a look at them on the way to the recycling bin.

Most were for penny stocks. I was curious how people would make money off them, so I checked it out and ran across penny stock scams. I’m pretty sure that what I was getting were part of pump and dump schemes. If you haven’t run across one before, here’s the basic anatomy of a pump and dump scheme:

The 5 Phases of Pump and Dump

Phase 1: The scammer buys a number of shares in what’s generally a penny stock or otherwise non-NYSE/NASDAQ stock.

Phase 2: The scammer convinces a bunch of people that this stock is the next hot thing and about to break away. That’s where the fax comes in. It was probably part of a whole campaign the scammer had worked up to spam fax lines and e-mail accounts with hot tips on this penny stock.

The scammer probably also popped onto investing forums and chat rooms in an attempt to reach hopeful investors. Maybe s/he even wrote a few blog posts and tweeted about it. The internet provides a variety of means one can use to spread information—true or false.

If this phase doesn’t work, the whole thing falls apart. However, there are a lot of people out there looking to get rich quick who just might fall for it. Unfortunately, only the scammer gets rich from this.

Phase 3: Those who believe the hype start buying the stock. Per the usual laws of supply and demand, greater demand for the same amount of stock means that the price goes up. This may provide such immediate reinforcement of the belief that the stock is breaking away that the dupes start buying more.

Phase 4: The scammer decides it’s time to sell. S/he can’t get too greedy or the whole thing will die down again. It’s important for the scammer to act while the frenzy is still high and long before people realize they’ve made a mistake. Maybe even within a few hours.

A few other lucky individuals will realize what was going on (some may have known from the start and be trying to work the scam for themselves) and will get out before the scam dies down.

Phase 5: The stock falls. Because more people are trying to sell than were selling before, the stock will actually go below the price it was when the scam started. In time, things will even out (unless the whole stock goes under). But people trying to get out of the wreck will likely lose some, if not most, of the money they spent.

On Avoiding Pump and Dump

My advice would be simply to avoid penny stocks and generally stick to an investing plan that fits your needs. Mine involves a number of indexes, for example. The SEC has advice for evaluating stock tips and avoiding the pump and dump:

  • Consider the source: Spam mail? Random faxes? Bulletin boards? Strangers? If your financial adviser suggests buying a stock, that’s one thing. If a stranger does, that’s another.
  • Find out where the stock trades: Most of these stocks don’t trade in the New York Stock Exchange or the NASDAQ. They’re “over the counter.” OTC stocks are normally riskier.
  • Independently verify claims: Of course, a lot of these claim to have inside information. But see if you can find any grounding in fact.
  • Research the opportunity: Do the same research you would only and stock and company.
  • Watch out for high pressure pitches: Pump and dumps don’t want you taking the time to do the above research, because then you won’t buy. They also want everyone buying at once. So they’re often “once-in-a-lifetime” and “limited time only.” Maybe you’ve only got a few hours to use this special information before everyone will know and you’ll lose the advantage. Don’t give in to the pressure.
  • Maintain a healthy skepticism: Seriously, why would a stranger give you a hot stock tip? Wouldn’t it be better for them to make their own money from it? Or tell their friends?

Interested in learning more about scams? Check out Pinyo’s e-mail encounters with a Craigslist scammer.

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Pinyo August 19, 2008 at 12:21 pm

That’s a really good overview of the stock scam. I get these stock tips mails all the time and I usually dump them as fast as I could.

And thank you for highlighting my article.

Michael August 19, 2008 at 2:06 pm

It’s possible to profit from stock scams by aggregating and monitoring them. http://www.qwoter.com/spam.php

mrsmicah August 19, 2008 at 2:18 pm

@Michael, that site looks quite useful for figuring out what sorts of scams are going on. But I wouldn’t feel comfortable getting mixed up in one a) because I don’t feel it’s ethical to profit from a scam, even if you’re not the scammer and b) if I didn’t worry about the ethics, I don’t trust like investing that’s time-critical.

Sometime in the future it’s entirely possible that I’ll buy maybe $25 or $30 in REALLY low-priced penny stocks for pure entertainment value. Because owning a large number of shares of something worthless would amuse me as long as I did it on purpose. And I didn’t have to store it (stocks are handy that way). And it didn’t cost much.

Steward August 19, 2008 at 6:04 pm

I think I wouldn’t mind buying a penny stock just to drop the fact that I owned 3000 shares of a stamp company. It would make me sound rich, and possibly famous. Then when the stock jumped by 20% (lets say $0.01, from $0.05 to $0.06) I would sell off all my holdings and brag about how I made a 20% profit on my holdings.

That would make me happy.

mrsmicah August 19, 2008 at 6:10 pm

Exactly, Steward! As long as I considered it entertainment then it could be fun. The trouble comes when people try to get rich from it.

Scott @ The Passive Dad August 19, 2008 at 11:09 pm

It’s funny, when I worked for an investment bank I would receive some really cleaver faxes. On one occasion I really had to do a double take and actually go to Bloomberg and check to see if the stock was legit. The fax had a hand-written note that said something like “Hey Bill, you gotta see this one” or “Bill, I just picked up 10,000 shares and you should do the same before the government ruling comes out”. Very clever deceptive spamming that was being done. I think now more of these faxes are being used and they certainly do catch you attention.

Jeff August 20, 2008 at 8:29 am

mrsmicha, loved your write up. Not sure I share you aversion to penny stocks. http://www.timothysykes.com/ has some great information on how to profit from penny stocking and he really does a great job cutting through the industry BS.

Paul August 20, 2008 at 9:44 am

Great article. I never thought about this subject before. Thanks for highlighting it!

Daddy T August 21, 2008 at 9:04 am

I like the wisdom of your “maintain a healthy criticism. You are “right on the money” there.

JohnMathew December 14, 2010 at 11:46 pm

Thanks everyone. Really good stuff. I greatly appreciate the detail. After reading this, we’ll have to think more about it.

Booki May 6, 2013 at 10:27 pm

People should avoid trading pump and dump stock at all cost, or they’ll lose all their money. There is actually a few sources that provide a daily pump and dump penny stock watch list.

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