What Is a Penny Stock Pump-and-Dump and How Do You Spot Them?

It's tough enough to identify stocks that are a good bet without white-collar criminals complicating the process. Pump-and-dump schemes are illegal, and they have cost investors hundreds of millions of dollars, according to the Federal Bureau of Investigation. The motive behind a pump-and-dump campaign is to profit by creating a false sense of immediacy surrounding some inexpensive, under-the-radar company. Once unsuspecting investors buy shares, the price of the penny stock rises and the architects of the scam abandon ship by selling their stakes, taking investors' money and hopes of future returns with them.

Penny Stocks

Before you can spot a pump-and-dump, you should be familiar with penny stocks, which generally trade in the over-the-counter markets -- less formal and more lightly regulated trading platforms than major exchanges. The price for penny stocks rarely gets above $5. Other common characteristics shared among penny stocks are market capitalizations -- a measure of a company's size -- of less than $100 million and thin trading volume, meaning investors buy and sell fewer shares of penny stocks vs. larger more well-known businesses.

Spam

You could find evidence of a penny stock pump-and-dump scheme in your email account's spam folder. The architects of such schemes are known to distribute mass emails containing fraudulent information in hopes of making a market, or creating buying activity, in a stock. This was the approach taken in an alleged pump-and-dump scandal involving shares of Xumanii. An individual investor became suspicious of emails from fabricated accounts containing erroneous analyses of the company, predicting unsubstantiated stock-price gains, said a 2013 article on the CNBC website.

Guarantees

If a stock pick seems too good to be true, it probably is. The criminals behind pump-and-dump schemes are known to promise investors that a single investment is guaranteed to multiply or that it will make them rich. Such promises are hints of potential fraud, as the stock market doesn't carry any guarantees for profit. Pump-and-dump activity has been known to surface in Internet chat rooms in addition to social media websites, including Twitter and Facebook, said a 2013 article on the "Forbes" magazine website.

Common Sense

Another way to avoid pump-and-dump schemes is to remain vigilantly informed about events in the investment community. With access to blogs and news from trusted places, this isn't as random as it seems. For instance, in July 2013, the Columbia Journalism Review alerted readers to a pump-and-dump scheme that was avoided at a major finance publication. In this case, the perpetrators characterized Goff Industries, the penny stock in question, as a business that morphed from social recruiting to gold mining. A dose of healthy common sense would have been enough to give investors pause in this case.