The network effects of pump and dump
Amongst many components of the financial industry, the stock market is heavily influenced by the effect of people’s decisions. Often the goal of profitable investing is to foresee the decision of others and make trades before others. Some have notoriously attempted to influence the decisions of the others for their own final gains through schemes such as “pump and dump”. You may have heard about the term through “The Wolf of Wall Street” or perhaps through famous examples such as the RCA and “The Radio Pool”. Many have even voiced opinions that the surge in the value of Bitcoin is an elaborate pump and dump scheme.
Investopedia defines a pump and dump as a “the illegal act of an investor or group of investors promoting a stock they hold and selling once the stock price has risen following the surge in interest as a result of the endorsement”. The mechanism involves purchasing large quantities of shares in a company and artificially increasing the demand for the shares, which increases the price of the stock. They are only effective on small, yet publicly traded companies (often on lower-tier stock exchanges) that are prone to volatility and unstable price movements. This is because the stock price of smaller companies is often more flexible to change due to the smaller volume of trades. A pump and dump wouldn’t work on a bigger company such as Google as the volume of trades are often too great to be effectively affected by advertisements or a single entity.
The savvy scammer would first invest a substantial amount of capital into a micro-cap company, which would increase the price of the stock. Then, they would advertise the increase to unsuspecting victims of the scam (“The Pump”). The first picture shows a “seemingly credible” post on the growth of Montalvo Spirits, Inc. They are often advertised as a “hot tip” or “the next big thing”. The victims who are persuaded by the marketing campaign would then purchase the stock, further driving up the price. The gains of the stock are compounded, further persuading individuals to purchase the stock through the network effect. Finally, the scammer would quickly sell its shares in large quantities (“The Dump”). The scam effectively profits the scammer and the victims find their shares at a much lower price than when they bought them.
The network effect in play allows for the fluctuation of the stock market and causes the pump in the pump and dump where the decision of many influences others. While established networks often benefit society by establishing connections across the world, it can also be exploited to harm many.
Sources:
https://www.investopedia.com/ask/answers/05/061205.asp
https://www.goodetrades.com
http://thenudeinvestor.com