Page 1 of 6
Archives of Business Research – Vol. 9, No. 8
Publication Date: August 25, 2021
DOI:10.14738/abr.98.10747. Samsa, G. (2021). A Primer on Pumping and Dumping: How Hedge Funds do it and How Others Might Profit. Archives of Business
Research, 9(8). 175-180.
Services for Science and Education – United Kingdom
A Primer on Pumping and Dumping: How Hedge Funds do it and
How Others Might Profit
Greg Samsa, PhD
Professor, Duke University Department of Biostatistics and Bioinformatics
ABSTRACT
Pumping and dumping occurs when the price of a stock is artificially inflated and
then drops. Here, we illustrate how hedge funds can accomplish pumping and
dumping, and argue why this strategy is likely to be successful for them. We
illustrate why writing a short-term in-the-money covered call option might
constitute an informed speculation when pumping and dumping is suspected. In
contradistinction to the usual practice, estimating the returns of a strategy which is
based upon the predictable characteristics of pumping and dumping would be best
tested prospectively, and social media communities might fruitfully participate in
such research.
Key words: covered call options, investment returns, pump and dump, social media
communities
INTRODUCTION
Not all of the assertions on Reddit are nonsense. The prices of some stocks might actually be
manipulated, protestations to the contrary notwithstanding. Even paranoids can have real
enemies.
One form of market manipulation is "pumping and dumping", where the price of a stock is
artificially inflated and then drops. Here, we illustrate one way by which pumping and dumping
can be accomplished, and how this takes advantage of predictable characteristics of equity
markets. We then describe how individual investors can attempt to profit from this behavior,
and then finally discuss how the resulting trading strategy might be tested.
DEFINITION OF PUMP AND DUMP
A "pump and dump" is "a form of securities fraud that involves artificially inflating the price of
an owned stock through false and misleading public statements, in order to sell the cheaply
purchased stock at a higher price" [1]. Pumping and dumping can also refer to "manipulation"
which might not reach the legal standard of fraud. For example, purchases (sales) of large
volumes of stock can cause its price to rise (fall). Assertions can be made on social media which
are indistinguishable from the usual speculative banter. This "non-criminal" version of
pumping and dumping is of interest here. For concreteness, we assume that the pumper is a
hedge fund which has sufficient resources to affect the price of the stock in the short term.
EXECUTING A PUMP AND DUMP: CONCEPTUAL RATIONALE
The pumper relies upon two relatively predictable characteristics of short-term market
behavior. First, that price momentum, which can be induced by buying or selling large numbers
Page 2 of 6
176
Archives of Business Research (ABR) Vol. 9, Issue 8, August-2021
Services for Science and Education – United Kingdom
of shares, will continue beyond the initial pump. The rationale is that much of the buying will
be done by entities whose incentives induce herd-following behavior (e.g., other hedge funds,
momentum-based mutual funds) [2,3]. Second, while short-term stock prices are at least
somewhat tethered to economic reality option prices are not, and instead are driven by the
volatility in stock prices during the time frame under consideration [4]. The impact of this
second characteristic is that, when either pumping or dumping takes place, inducing short-term
volatility in stock prices, option premia will predictably spike.
EXECUTING A PUMP AND DUMP: REQUIREMENTS
To execute a pump and dump, the pumper must trade in sufficient volume to influence stock
prices in the short term. An ideal stock to pump and dump is (1) highly speculative (and thus
likely to attract the attention of other hedge funds); (2) has relatively few shares traded (thus
allowing the pumper to affect the stock price without having to buy an excessive number of
shares); (3) has a robust options market (as illustrated below); and (4) is widely discussed on
social media (thus providing the pumper with a mechanism to influence opinions in the desired
direction). Often, a "meme stock" will have all these characteristics.
EXECUTING A PUMP AND DUMP: IMPLEMENTATION
Table 1 below illustrates an idealized version of a pump and dump. For simplicity of exposition,
we assume that the pumper doesn't engage in short selling at the apex. Buying is highlighted in
yellow, selling is highlighted in green. Purple highlighting indicates the effective purchase price
for an individual investor who purchases the stock and sells a covered call option. The time
periods in question might extend across multiple calendar days.
• Period 0 is the steady-state for the stock price. During the previous time periods the
pumper has accumulated short-term call options cheaply, the price being low because
in the absence of extreme price moves they will expire worthless.
• Periods 1-4 represent the pumping of the stock price, induced by buying large numbers
of shares even as the price increases, intended to induce momentum which in turn will
encourage other momentum-oriented speculators to buy. This can be coordinated with
a social media campaign.
• During period 5 the pumper moves into profit-taking mode. They try to sell
incrementally, so as to induce others to continue buying. The implied volatility of the
option contract is at a maximum.
• During period 6 the ruse becomes apparent, and the pumper sells aggressively even as
the price drops.
• During periods 7-9 the stock price gradually returns towards its baseline. In the absence
of pumping and dumping price volatility drops, as do option premia.
• Period 9 represents a new baseline for the stock price, perhaps a bit higher than the
previous baseline, in part because of the expectation of another pump and dump.
Page 3 of 6
177
Samsa, G. (2021). A Primer on Pumping and Dumping: How Hedge Funds do it and How Others Might Profit. Archives of Business Research, 9(8). 175-
180.
URL: http://dx.doi.org/10.14738/abr.98.10747
Table 1: Illustration of an idealized pump and dump
Period Stock price
($)
Short-term
option @1 ($)
Effective
purchase price
after writing
covered call
@1
Short-term
option @1.50
($)
action
0 0.70 0.02 0.68 0.01 Accumulate options over
time
1 0.80 0.04 0.76 0.02 Buy stock and options
2 0.90 0.07 0.83 0.04 Buy stock and options
3 1.00 0.10 0.90 0.07 Buy stock
4 1.20 0.35 0.85 0.15 Buy stock
5 1.40 0.60 0.80 0.30 Sell stock and options
incrementally
6 1.20 0.35 0.85 0.20 Sell stock and options
aggressively
7 1.10 0.20 0.90 0.10 None
8 1.00 0.10 0.90 0.07 None
9 0.90 0.05 0.85 0.03 New baseline
The profits to the pumper are as follows: (1) on the stock, bought at $0.80-$1.20 and sold for
$1.20-$1.40; (2) on the $1 call option, bought at $0.02-$0.07 and sold for $0.30-$0.60; (3) on
the $1.50 call option, bought at $0.01-$0.04 and sold for $0.20-$0.30. The stock profits are
derived by inducing momentum and then leaving the party early. The option profits for the $1
call options are derived from a combination of increasing intrinsic value and increasing implied
volatility. For example, at period 5 the option premium of $0.60 consists of $0.40 in intrinsic
value (i.e., the difference between the current stock price and the option strike price of $1.00)
and $0.20 in implied volatility (i.e., which is maximized at this point because of the recent
volatility in the price of the underlying stock). The option profits for the $1.50 call options are
entirely derived from an increase in implied volatility. The percentage gains on the option
trades are significantly greater than on the stock trades, although the latter are consequential
as well.
PROFITING FROM A PUMP AND DUMP
The individual investor is at a significant disadvantage throughout this process, in large part
because they cannot predict precisely when the pump and dump will either begin or end. For
example, when the stock price has risen to $1.20 it is uncertain whether the price will rise to
$1.40 (or more) and then fall, or instead whether this is the apex and the next move is
downward. Predicting the next stock which will be pumped -- in effect, attempting to buy the
stock on period 0 -- is a guessing game, which serves to bid up the prices of potential candidates
and ultimately reduce profits -- not even to mention the possibility that hedge fund managers
might simply find other kinds of stocks to pump and dump. Buying short-term call options (i.e.,
which generate the maximum return on a percentage basis) runs the risk of the pump being
delayed and having the options expire worthless.
Given the idealized description of a pump and dump illustrated by Table 1, there are various
points at which an individual investor could profit -- in essence, by buying up to $1.40 and