Anatomy of a Pump and Dump (And How To Profit From Them)
You’ve probably heard of the term “pump and dump”, a phrase popularized in the best selling book and subsequent box office hit, The Wolf of Wall Street. The story highlights the rapid rise to fame and fortune of a young trader, Jordan Belfort who makes his millions through trading small capitalization stocks via the pump and dump method (albeit using illegal methods which landed him in jail).
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For those of you who haven’t seen the movie and aren’t familiar with the term, a pump and dump is characterized by the rapid rise and equally rapid fall in the he stock price of a company. It’s a phenomenon typically seen in penny stock trading – a penny stock being a company with a very low share price and market capitalization.
Money is made from a party (individual, brokerage firm etc) buying into a stock, then engineering a “pump” or rapid rise in the share price. They then sell their shares at the height of the speculative mania for a significant profit.
Once this outfit finishes distributing their holding, price then falls back just as rapidly as there is no longer any “big money” to keep the price of the penny stock afloat. This results in big loss for those that bought into the hype and purchased stock near the peak – usually poor old unsuspecting mom and dad investors.
Pump and dumps are partly a symptom of human psychology – the allure of “getting rich quick” drives a speculative mania as people clamber to get aboard the next “big thing”.
I also think a lot (if not most) pump and dumps are partly engineered by institutional or “pro” money that’s able to get in early prior to the pump, then has enough funds to keep the pump going just long enough so that they can liquidate their position for a hefty profit.
Regardless of the mechanics behind them, I have spent a lot of my time at the speculative end of the stock market and I feel like I’ve developed a pretty good insight into penny stock trading, and how to buy penny stocks.
The rest of this post is dedicated to showing you exactly how I’m identifying stocks right now, that have a high chance of seeing quick, explosive gains in the short term (1 to 3 months).
You see, I’ve identified a tell tale sign that a pump is coming, and I’ve used this indicator to make money time and time again. This indicator is so simple, yet it’s surprisingly predictive.
I’ll get to this indicator in a second, but firstly I think it’s important to look at exactly what a pump and dump looks like, as well as examine the key “ingredients” (conditions) that I look for before I’ll consider a stock a potential “pump” target.
So what does a pump and dump look like?
I’ve seen a HEAP of pump and dumps throughout my time in the markets and I’ve unwittingly been a part of them many, many times.
A text book example is shown below in an annotated chart from one pump and dump I was personally caught out by in my early days. The company involved in Inca Minerals, a mineral exploration company searching for porphyry copper in Peru.
Porphyry copper deposits are hard to find, but are extremely lucrative – the largest copper mines in the world are porphyry’s. Speculation was rife that Inca had hit something big on their first drill hole, providing the ideal conditions for a pump.
The share price went parabolic, rising over 630% in the space of seven trading days. It then fell by up to 50% from it’s peak over the next few weeks as the “smart money” sold out for a hefty profit. They were able to sell into the demand created by average punters (“dumb” money) like myself who were continuing to buy into the hype while we waited with baited breath for the drill results.
The final capitulation selling seen by the huge “gap down” actually came as a result of the company announcing they had hit nothing in their first hole. Unfortunately I waited for results and was caught out by the big gap down. Lessons learned!
What kind of stocks get pumped?
I think it’s also important to discuss the conditions that are necessary for a stock to be a candidate for a pump & dump. Without these conditions, it’s very unlikely that a stock will have the right “personality” to support a pump. There are four main “pump-worthy”conditions that I have come across:
- A very small market capitalization. What constitutes “small” depends on what exchange you’re trading on. In Australia (where I do most of my trading) this mean less than $30 million, and often less than $10 million. In the US, this typically means any stocks with a market capitalization under $100 million and stock price under $5. Generally speaking, the lower the better.
- Very little interest in the stock. This will be characterized by extremely low volume and is often synonymous with an aimless or sideways trend. This condition allows for the stock to be slowly accumulated at low levels over a period of time, prior to a pump.
- The company must be in a “sexy sector” where speculation regarding a breakthrough announcement can result in significant “FOMO” buying. Common sectors include:
- Technology – next generation microchip, the next viral app, anything internet or social media related etc.
- Biotechnology – cancer drugs, cures for disease – anything drug related.
- Mineral Resources – anyone drilling for the next “big deposit”.
- Oil and Gas – It’s not called black gold for nothing.
- Imminent news flow – the company must have some potentially “game changing” activity on the cards, with significant news flow likely in the coming months. Something like the start of a new drilling program at a highly prospective tenement, drug trials for a potentially game changing cancer treatment, or the launch of a new and exciting phone App.
Now that we know what a pump and dump looks like as well as the types of stocks that experience this kind of trading activity, it’s time to show you how I identify these stocks before the pump, so that I can get in early, make bank in quick time, and get out before the inevitable dump.
How to find stocks BEFORE a pump, so you can get in early & ride the profit wave:
I lost a lot of money by playing the role of “dumb money” in my early years in the markets. I would buy into the hype wayyyy to late and would be the one without a chair when the music stopped.
The one good thing to come from all those painful experiences is that I gained an intimate knowledge of how these type of penny stock trading patterns play out. It’s helped me discover one simple method for identifying stocks BEFORE they are pumped (or at least the very beginnings of the pump).
So how do I do this? Quite simply, I look for subtle signs of accumulation in stocks that have all the characteristics I described above.
Identifying accumulation can be very lucrative because there’s only a handful of reasons why someone would be slowly and methodically accumulate a “dog”, penny dreadful stock while no one else was interested. The two main reasons are;
a) They see value in the company and anticipate a significant future rise based on improving fundamental factors, or
b) They plan to accumulate a position and use the hype surrounding pending news flow to pump the stock to the heavens.
I hope it’s obvious that neither option is a bad one the switched on investor!
So, how do I identify accumulation?
It’s actually far simpler than you may think.
I find all of these stocks using technical analysis. You see, I’ve found one key set of technical indicators that seems to be able to identify these stocks, pre-pump, time and time again.
So what have I been using to find these runners? It’s all about Money Flow indicators.
I won’t go into the nitty gritty as to how money flow indicators work, other than to say these indicators take into account both volume and price movements.
They also take into account where price closes within the trading range for a given time period. The theory goes that closes in the upper half of a trading range within a time period indicate buying, where as closes in the low end of the range indicate selling.
There are a range of indicators that fall into the over all “money flow” category, all with their own subtle variations. However, to keep things simple I’ll stick to my favorite – an indicator developed by Colin Twiggs which is aptly named Twiggs Money Flow (TMF). If you want more information regarding how TMF is calculated, click here.
How do I use Money Flow indicators to find stocks that show signs of a big rise ahead?
I look for stocks that at first glance look completely unloved (i.e. very little action) but have a positively trending TMF. Often these stock will be aimlessly trading in a sideways pattern with little direction, and it will seem like nothing out of the ordinary is going on.
However, when you load up your technical indicators, you’ll notice there has been a slow, methodical rising trend in TMF – a sure sign that someone is accumulating the stock on the sly.
An important part of the setup is that price cannot be rising dramatically at the same time. A small rise is fine, but it shouldn’t be in a clear trend, or breaking any historical resistance levels.
Clear as mud? Here’s a couple of recent examples of annotated charts taken directly from my very own trading diary which should help make things a little clearer:
Triton Minerals (TON) was accumulated from about march through until mid June, 2014 as shown by a slowly up-trending TMF, even though price was doing nothing but moving sideways, or even slightly downwards.
Price broke out explosively around June, reaching an all time high of just over $0.90. During this time, TMF never made a new high, and has continued to trend downwards since, along with the share price, which now sits almost where it started, pre-pump.
Mission NewEnergy Limited (MBT) was clearly accumulated prior to it’s massive pump earlier this year. Note the typical rising TMF trend with little to no movement in price leading into the pump – no doubt about it, someone was getting themselves set.
The stock was then pumped to the heavens, rising from $0.01 to $0.315 – a whopping 3050% rise in a single day!
Of course the stock came crashing down just as fast as it rose, and now trades around the 5c mark.
My final example is that of Collaborate Group (CL8), probably my most successfully traded stock to date. CL8 shows that typical “aimless” sideways price action typical of illiquid penny stocks. However, a close inspection of TMF shows accumulation in the background since about November 2014, as shown by the rising trend line in he TMF indicator.
It was no surprise then to see an explosive breakout following this period of accumulation around mid January, reaching a peak of 3.5 cents for a total gain of 170% in 4 trading days.
As per the script, TMF never made new highs during the pump, signalling distribution. Following this, price slowly drifted downwards once the big money left the station and retails holders eventually lost interest (or sold in panic) and sold out, one by one.
Now, they say history never repeats, but it often rhymes. One interesting thing about penny stock trading, is that these pump and dumps will often happen to the same stock over and over again. When this happens, the type of patterns you will see in the charts will look almost identical. CL8 provides a great example of this.
The chart below shows that CL8 was pumped a second time, following a second period of almost identical accumulation. I was able to spot this accumulation early and bought in, ready for the pending rise that I thought was highly likely.
Sure as night follows day, we saw an almost identical price rise (and equally identical fall) following this second period of accumulation. By identifying accumulation using Money Flow indicators, I was able to get in early and profit from the pump that followed. It’s as simple as that.
How do you know when to sell?
Ok, so maybe it’s not all that simple, because identifying accumulation of stocks is only one part of equation.
The other major part of mastering penny stock trading is figuring out when to sell a stock. Believe me, this is probably the hardest part, because it’s very, very hard to sell a stock that is rapidly rising. It’s probably the single biggest thing I’ve struggled with in my time in the markets to date.
I’ve constantly struggled with thoughts like “but what if the stock keeps going up another 10%, 20% or even 100%+“. For some odd reason, the brain seems to really struggle with the concept of missing out on future gains, rather than focusing on being happy with the gains you have made (at least mine certainly does).
I’m going to be the first to admit that whilst I feel I’ve developed a real knack for finding penny stocks that are ripe for a rapid rise, I haven’t yet mastered the art of picking my exits.
In saying that, there are a few strategies I use to help me identify a good time to sell:
- Spotting when price rises are happening on ever decreasing volume. Think of trying to push a heavy boulder up a steep hill, treating volume like momentum. You get a nice big run up on flat ground, building momentum. The boulder will remain in motion, moving up the hill, until it stops. Before it stops, velocity and thus momentum will gradually slow down. If you spot price rising on ever decreasing volume, it’s likely a good time to consider selling.
- Identifying a “buying climax“. A buying climax is kinda the opposite to point 1 above, whereby price moves rapidly upwards on huge volume, but that volume is either a) used by pro’s to distribute their remaining holdings and/or b) exhausts the remaining buyers so that there is no more money to keep the price moving northward. This is usually shown in charts by either a wide spread candle that closes low (with a big upper wick), or by a wide spread up candle that is followed by a wide spread down candle, closing near it’s lows.
- It’s less important when it comes to pump and dump penny stock trading, but historical support and resistance levels can also indicate good times to sell. I consider selling when price approaches historical resistance levels, although I also take into account other technical setups like the ones mentioned above.
- Using trailing stops. This is probably one of the most successful techniques I’ve used so far. If you’re not familiar with what a trailing stop is, read here. Basically, once a stock has risen a set amount, usually 20%-30%, I implement a “trailing stop”, whereby the stock automatically sells if it falls a set percentage from it’s highs. It’s not the most technical way to trade, but it helps take the emotion out of trading. I usually set a wide stop (25%-30%) as penny stocks are typically highly volatile.
Other factors to consider
Now, I should point out that this post has probably made it all seem a little bit overly simplistic. Before taking any position in a penny stock (other than a rapid fire intra-day trade), I make sure I do a little bit of due diligence to make sure I’m not going to get caught out by something left field. Three key things I look into first are:
- How much cash does the company have? If a company is almost out of cash, you can almost guarantee someone is pumping the stock prior to a capital raise. You DO NOT want to be caught in a trading halt for a capital raise. Check the companies cash position by loading up it’s most recent quarterly report.
- Does management hold a decent chunk of the company? There are many lifestyle companies out there, so beware of companies where management do not hold a significant portion of the company, as their interests are unlikely to be aligned with shareholders. Not as important for a short term trade, but if you plan to hold longer term, this is very important.
- Has there been a recent capital raising at a discount to the current share price? If there has, price almost always drifts back to the capital raising price. Wait for that to happen before taking a position.
To sum it all up, the market is a highly complex beast and there is no one trick pony that will help you pick a 100% guaranteed winner. The method I’ve outlined in this post is pretty simple, but when it comes to investing, I’ve often found things work the best when I keep things just that – simple.
It’s easier than you may think to identify stocks that have an above average chance of providing short term gains – just look for signs of accumulation. One of the best way I’ve found for doing this is to look for divergence between price (either sideways or downwards trending) and money flow indicators such as Twiggs Money Flow (positive trending).
Does identifying patterns typical of accumulation guarantee that you’re onto a winner? Absolutely not, but I’ve found it greatly increases your chances of picking a winning trade or investment. I can honestly say I’ve made the majority of my profit in the past 18 months, both on paper and realized, using the method I’ve just described in this post.
Always be sure to conduct your due diligence and buy in when you see this occurring in otherwise unloved stocks. Beware though, you may have to be patient to accumulate a position as these stocks are usually highly illiquid.
Hold the stock until you either identify a good time to sell (something I’m still working on), or you’re stopped out of your position. Never be afraid of locking in profits – the penny stock trading game is a highly risky and volatile space and profits can disappear in the blink of an eye. It’s not an activity that’s recommended for those that are risk averse!
Also remember that mastering anything takes practice – Giving it a crack and learning from your mistakes is the only way you’ll learn to master the art (and it is an art) of penny stock trading.
I’m very interested to hear what you think, so please feel free to comment below or flick me an email with your thoughts, questions and comments. In particular, I’d love to hear how you identify a good time to sell fast moving speculative stocks, as it’s one aspect I’m currently focusing on improving.
The Nude Investor
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I just want to clarify one thing; in the past, a lot of pump and dump activity has been highly illegal. In the case of Jordan Belfort, the “pumping” part of the equation was achieved through the mis-allocation of clients funds, insider trading and the spreading of incorrect, market sensitive information.
Around the world, market regulators are clamping down heavily on this type of behavior following the global financial crisis and the penny stock trading scene is a lot more “above board” nowadays.
I am not a legal expert in financial law and I am not, in any way, making comments regarding the legality or otherwise of the trading activity observed in the stocks I have mentioned.
As far as I am aware, all trading activity I have mentioned in this post is completely legal. No charges or actions have been lodged in relation to the trading activity described.
Furthermore, trading based on non-public, material company information (i.e. insider information) IS illegal, and the receipt of any insider information should be reported to the relevant authorities immediately.