A reader wrote to me recently asking about the proliferation of spam emails concerning individual stocks:
I often get two or three spam emails a day touting a specific stock. I’m smart enough to realize that this is some kind of scam, but how exactly does it work?
This type of scam is called a pump and dump, and you’re far better off ignoring such emails completely than looking at them at all.
They all generally follow the same form: they identify a company and a stock you’ve likely never heard of and give some astounding reason as to why this stock is going to go crazy in the next day or two, usually some sort of “news” that came out after the market closed yesterday.
Here’s exactly how the scam works:
1. Overnight, a con man sends out the spam emails identifying this “hot” company. The email usually encourages people to track the stock.
2. The next day, right at the start of trading, the scammer buys a fair amount of the stock, causing it to make an initial jump in price.
3. The scammer then often posts on message boards or on blogs about how this stock is hot, pointing to the huge upward trend to start the day.
4. The scammer usually continues to buy in bits and pieces throughout the day, keeping the demand up and lifting the price even higher, but this isn’t always necessary.
5. At some point during the day, though, the scammer executes a sell-limit order, meaning that his brokerage is to sell all of his stock if it reaches a certain level. For example, the stock might start the day at 1, the scammer is able to buy enough so that the price goes up to 6, and he executes a sell-limit order at 10, meaning that the instant the stock hits 10, all of his shares go up for sale.
6. Often, after a half day of doubling or tripling in price, some of the scammed people decide to buy in, driving the stock even higher.
7. When the scammer’s sell-limit price is surpassed, all of his shares go up for sale at the elevated price. Anyone who has fallen for the scam will then buy these inflated stocks.
8. The scammer gets out of the stock entirely, selling all of them at an inflated price and making a big profit. The people who believed in the scam are now holding onto vastly overvalued stocks, which will rapidly plummet in price down to their low level.
If you buy this stock, you’re going to be the person left holding the overinflated stock that’s rapidly losing value. In other words, you were just talked into buying a $1 stock for $10 or more – and very quickly, that stock will go back to $1.
How can you fight this? First of all, ignore all emails promising a hot stock tip. If it’s an unsolicited tip from someone you don’t know, someone’s out there scamming a buck – and you’re the one who’s going to get scammed if you pay attention. Second, if you must follow up on a stock tip, do some research. Find out if the company actually files reports with the SEC – if they don’t, that’s a sure sign of a giant scam. If they do file reports, very, very carefully investigate the “big news” – and only accept the news if it comes from reputable sources (AP, Wall Street Journal, and Reuters, basically). Better yet, don’t waste the time and just delete that email entirely – it’s not worth the risk.