15 December 2020 • 8 min read
The global cryptocurrency markets are gaining traction at an increasing pace and attracting more investors all the time. While there are many legitimate opportunities in this sector, the lack of regulation in many nations opens up the door to abusive market practices – like the nefarious crypto pump and dump scheme.
If you have been wondering how bad actors make pump and dump schemes work, we can help you understand this and also how to protect yourself against them.
Many investors want to be in smaller tokens, as there are always going to be stories about massive gains that were generated by getting in early. Of course, there will be truth to some of these stories, and sometimes a small token can create big returns.
If you want to trade smaller tokens with the goal of winning big – it is time to understand the pump and dump scheme.
The pump and dump scheme isn't new, as it has been employed extensively in the equity markets for a long time. The idea behind the scam is very simple. A person or group will buy a large amount of a security or a token that is thinly traded (this aspect is very important), and by doing so, the price will rise.
As the initial buying causes a rise in price, the entity behind the buying will begin to promote the asset, generally in informal media. As more people jump into buying, the price will rise further, and people will tend to get excited about the prospect of further gains.
The entity that was behind the initial buying and publicity push is now ready to cash out their holdings at a much higher price level, and lock in some big gains. Anyone who has come to the market late in the cycle will be stuck with the asset and no more buyers, which is the end of the scheme.
In general, once the initial buyer who began the scheme exists the markets, and the publicity campaign wanes, the prices will fall, and anyone who holds the shares or tokens will see big losses. That, in short, is the pump and dump scheme.
Realistically, there is more to these schemes, and anyone who is dealing with inexpensive, thinly-traded assets needs to know what to look for when buying into a rally, or a hot, new investment thesis.
When an investor is trading on the small side of the crypto markets, there are some things that are very important to keep in mind. As we will see, the lack of regulations and the global nature of the crypto markets makes it the perfect place for bad actors to operate pump and dump schemes, and there are few consequences for scammers who know how to take advantage of greedy traders who aren't thinking the deal through.
In the days of equity pump and dump schemes, the people behind the scam would use call centers to push shares on private investors, often using incomplete or misleading information to make sales. With this set-up, it was relatively difficult to connect with potential victims when compared to the internet era.
Today, it is much easier to distribute information, which has supported scammers who use the pump and dump model to make money. In addition to portals like Reddit and Medium, there are platforms like Twitter and Telegram that help bogus information spread quickly.
Another factor to consider is the fact that while many equity-based schemes used questionable information to make the sale, outright lies were relatively rare. There is a good reason for this.
Most of the brokers who were selling worthless shares were actually registered brokers, and lying may have cost them their license and had other legal consequences as well.
In the crypto sphere, completely false information is used in pump and dump schemes as the people running the scam aren't subject to any regulations, and regulators are just beginning to go after people who are acting in bad faith.
Clearly, international scamming operations are still very difficult to control, which makes it almost impossible to go after scammers who know where they won't be prosecuted for online fraud.
The biggest problems many retail investors have are emotions, and the desire to make large gains quickly. It is these motivations that a pump and dump scheme operator exploit, and it is hard not to assign some amount of responsibility to the victim of these operations.
Keep in mind that professional money managers would be ecstatic to produce 20% annual returns, which should help any investor who goes into every deal hoping to double their capital to realize how unrealistic these kinds of expectations are.
Anyone who wants to invest in small tokens that aren't widely traded needs to be very good at research, and knowing what a company or platform does well before the tokens are bought. Investors who are willing to buy a token that just went up by 50% that they just heard about should take some time to look deeper into the deal.
There are a few fool proof last-minute checks you can do before deciding to invest your money in a project and we're going to outline them right here.
Before capital is put at-risk, it is very important to analyze the investment thesis that is driving the allocation and put it through some amount of scrutiny. For example, if the thesis is: the token is going up in price and I just got a message on a Telegram group – further analysis is needed.
It is very easy to share totally false information on popular platforms, and the price appreciation of a small token is simple to manipulate. Scammers may not have to do much promotion past the first round or two, as excited market participants buy tokens and send the tip out over trusted channels.
Another area of token information to be cautious with is online media or YouTube channels that specialize in distributing tips on what small tokens to buy. These sources of data are totally unregulated and may be paid to promote a token or project.
Take a look over the past trading volume of the token that is flying up the chart. If there is a large buy over the course of a week, and then thin volume pushing the token up, be careful. It is important to be able to exit the position without moving the market, which is a function of the average volume of a token or share.
Most legitimate token projects will have a solid history of media coverage and company communication. Any viable project will likely have a presence on both GitHub and Medium, and it is a very good idea to see what it has been posting on its media portals.
These have been instances of bad actors buying up an old, defunct token, and running a pump and dump scheme. Make sure the token has a legit development team behind it. If the token has a Medium account that has been dead for years, that is probably all you need to know.
The people who are developing a project are as important as the idea they are working on. Management matters and many investors consider the management team to be one of the most important parts of an investment thesis. Keep in mind that people can lie about who is working on a project, so doing real research is necessary for anyone that wants to avoid getting scammed.
Most pump and dump schemes are able to defraud investors because people think that getting in early to a great project will create huge returns. In a sense, this is true. However, it is easy to forget that most companies fail, and when they go down, all the capital that was invested is lost.
In the world of Venture Capital (VC), it is estimated that three out of every four (75%) of VC-backed companies will fail, and take all the invested capital with them. These companies aren't scams – it is just risky to start a new business.
Getting in early means that an investor may make large returns, but statistically speaking, an early-stage investor has a 75% chance of being wiped out over the course of a few years' time. These aren't great odds, which is why VC is such a difficult market to make lasting profits from.
There is a reason why pump and dump schemes target unsophisticated investors – it is easy to have big dreams of making large returns, but professionals understand how much risk is tied up in any early-stage company.
Professionals also understand that the assets have to be sold to lock in profits, which means deep liquidity and a wide investor base for the asset. Watching a token fly up in value can be exciting to a new investor who doesn't understand how difficult it is to actually sell a large position into the markets, and that is exactly what the scammers are counting on to make money.
When an investor buys into the token that is a part of the pump and dump scheme, they are actually creating the gains for the scammers, who are selling into the markets at a much higher price than they paid. Be careful out there, and avoid these scams.
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