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Have you watched ‘Wolf of Wall Street’? The film very vehemently explained the pump-and-dump strategy.
Are pump and dump stocks illegal in India? Yes. Even then, Dalal Street has had its fair share of ‘pump-and-dumps’ in the past. Why? Some individuals love fast money. And what better way to earn than through market manipulation?
Time to dive into the infamous pump-and-dump strategy and why it is illegal in India?
Stock market pump and dump scheme explained
To put it simply, ‘pump-and-dump’ in the stock market is a strategy to manipulate the stock market. It consists of two elements – pump, i.e., to artificially inflate or hike the stock price through false and misleading information, and, dump, i.e., selling those shares at the inflated price.
In a pump-and-dump strategy, the stock price is artificially inflated. How? By spreading false information, creating unnecessary excitement around the stock, or providing false recommendations.
Pump and dump example
To understand this strategy further, let’s consider a simple example:
Assume an operator has bought 10,000 shares of company ‘ABC’ at a share price of ₹10. Therefore, he has invested ₹1,00,000 in the company.
Being an operator, he wants to increase the share price. But without the knowledge of stock exchanges. The simplest way to do so is by spreading false “positive” information about ABC.
The positive news can be either a big leader acquiring ABC or the company signing a high-value contract. By spreading this news, investors’ interest in the shares peaks.
Investors/traders begin buying ABC shares, leading to a hike in the stock price. Say from Rs. 10 to ₹20, 25…etc. Let’s assume the price hikes to ₹30.
Now, the operator has decided to sell his shares. This renders him a profit of ₹2 lakh. While the investors are left with shares of an overpriced and overbought stock.
Why are small-cap companies the common target of pump and dump strategy?
Small-cap or small-capitalisation companies in India are those with an overall market capitalisation of less than ₹5,000 crore. Investors tend to bet big on such companies due to their high growth potential.
Let’s dwell into some possible reasons:
- Although capable of high growth, small-cap companies have limited press, news and corporate information open to public
- More often than not, these companies are not part of an analyst’s radar. And so, there may not exist any elaborate reports on their financials
- Their trading volumes are relatively low
Arshad Warsi Ban: A case study
Remember when Arshad Warsi and his wife, Maria Goretti, were banned from investing in Indian markets? Well, the Securities and Exchange Board of India (SEBI) took the call. Apparently, because Warsi and his wife were involved in stock price manipulation.
They used the same pump-and-dump strategy for hiking the price of two shares—Sadhna Group and Sharpline Broadcast Ltd.—in July 2022.
Warsi and his wife were not directly involved in executing this scam. But they contributed by increasing the share’s volume. Let’s look at some specifics of the case:
- Sebi discovered that two unnamed YouTube channels uploaded fake and misleading videos about both stocks. Not to sabotage the firms, but to falsely pump their share price.
- The videos claimed that Adani Group was all set to take over Sadhna and enter film production by collaborating with a giant American corporation. This deal would be worth a gigantic ₹1,100 crore.
- As predicted, these videos gained millions of views via paid marketing tactics.
- This being positive news, investors started bidding their money on these shares.
- The share price increased and the fraudsters spreading fake news gained massive profits by selling off their shares.
Result: Innocent investors were left with shares of an overvalued stock. All because of a hoax.
As many as 31 entities were involved in this scam, including Warsi and his wife, making profits worth ₹29.43 lakh and ₹37.58 lakh, respectively.
Of course, SEBI did seize their profits and banned the duo from the market.
Conclusion
The ultimate takeaway is this: Today, a lot of market information is available online. From both credible and fake sources. Whatever the case, it is important for you to do a background check on the stock.
FOMO on stock profits definitely hurts. But not as much as getting influenced by fraudsters and investing in an overvalued stock!
FAQs
Pump and dump schemes can temporarily inflate the price of a stock through false or misleading statements. The perpetrators buy the stock before the price rise and sell it at its peak. While this may work for the schemers in the short term, it is illegal and unethical. It manipulates the market and can lead to severe legal consequences.
In a pump and dump scheme, the losers are typically the unsuspecting investors who buy the stock at inflated prices based on the false hype. Once the price is pumped up, the fraudsters sell their shares at a profit, causing the stock price to plummet. The latecomers, who believed in the misleading information, are left with significant losses as the stock value crashes.
Pump and dump schemes are not safe and are categorically illegal. They involve artificially inflating the price of a stock through false or misleading statements, only for the orchestrators to sell off their holdings at the inflated price, leading to a subsequent crash. Such activities are considered a serious form of market manipulation and are strictly prohibited by regulatory authorities. Participants, including those who initiate and those who knowingly join in, can face severe legal consequences.
After a pump and dump, the stock price typically crashes once the fraudsters have sold their shares. This leaves many investors with worthless shares, far below their purchase price. The market may also lose trust in the stock, making it difficult for the price to recover. Regulatory authorities may step in, leading to investigations and sanctions against those involved.
To avoid pump-and-dump stocks, investors should be wary of stocks with sudden, unexplained surges in price or volume, especially if accompanied by aggressive promotion or ‘hot tips’ on social media or forums. Conduct thorough research, consider the source of investment advice, and be sceptical of investments that seem too good to be true. It’s also wise to focus on stocks with solid fundamentals and transparent financials