The GameStop (GME) saga earlier this year is an excellent microcosm of exuberance getting ahead of value, and a good reminder that enthusiasm about the stock market can also provide opportunities for people who want to fleece the unwary. Now, the GME and “meme stock” trading phenomena isn’t exactly a scam, the companies targeted by online traders were heavily shorted stocks that were (allegedly) trading at a discount to their true valuation, but they can still teach us a lesson about avoiding stock scams as the conversation around the stock looked similar to a classic pump-and-dump scheme.
In this kind of scam, operators buy a boatload of a cheap stock with nothing going for it but a story that can be sold. Then comes a high-pressure media blitz that pushes the stock’s price higher. In the case of GME, the fact that more shares were shorted than actually existed built in value as long as the company did anything other than go bankrupt because short sellers were obligated to buy back shares they had sold. The action of buying back borrowed shares drove the share price higher, which compelled other short sellers to also buy back shares, creating a phenomenon known as a “short squeeze.”
Once the squeeze began, online traders began promoting the stock on message boards and via social media, which then drew mainstream media attention which inspired other retail investors to begin buying shares. This frequently triggers a “fear of missing out” which makes otherwise rational people behave irrationally. This is the same emotional response that can make investors susceptible to traditional pump-and-dumps.
In the case of GME, shares peaked early in the year, rapidly sold off and then almost as rapidly bounced back before settling into a slightly lower 80-point range for the rest of the year.
With the traditional pump-and-dump scheme, the stock spikes from a low price (frequently just pennies per share) to a huge gain, the fraudsters sell out at the peak, leaving investors holding the bag. If you do this several times a year, you can make lots of money … and get indicted on charges that might get you 100 years in the federal pen.
It’s not uncommon to see solicitations for these types of stocks online. You’ll find a long, repetitive advertisement for the stock of a nanotechnology company or unknown tech company whose stock is now trading at about 60 cents per share. Great things are expected from this company, according to the ad, and from its stock. Ads will frequently contain language like: “We believe prospective returns of between 500% and 1,000% are realistic.”
With so much information out there, it can be difficult to distinguish between legitimate advice being provided with your best interests in mind, and stocks being promoted only to pump up their share price so the seller can make a profit. So what steps can you take for avoiding stock scams?
4 Steps for Avoiding Stock Scams:
- Find out where the stock is trading. A stock trading on the Nasdaq or NYSE has to meet stringent listing requirements, whereas stocks trading over-the-counter are subject to more limited reporting requirements, although that’s been made more robust recently. Listed stocks are generally not scams (although there have been exceptions).
- Look at the stock’s trading history. If the stock has little-to-no trading history, or if it was created via a reverse merger, be wary.
- Find out who runs the company. A legitimate publicly traded company will have a board of directors and senior leadership. A simple internet search of the names of company leaders can reveal if they have prior history with running companies (or scams).
- Consider the source. Is the ad or solicitation redirecting you to a website you’ve never heard of? Are emails coming from a trusted source?
Cabot Wealth Network doesn’t ever get paid a penny by anyone to promote any stock. We make our money by giving good advice to people who subscribe to our publications.
What are some red flags that tell you to avoid a stock at all costs?
This post has been updated from a version originally published in 2013.