Shorting Pump and Dump Stocks

One of the wonderful things about shorting stock promotions, or pumps and dumps, is the chance that the regulators might come in and nail them while you are short.

This makes for instant profits.

Let's take the example of Life Stem Genetics, Inc.  LIFS.

I received in the mail a promotional brochure telling me that buying LIFS is like owning stock in the fountain of youth.

Checking the chart, I found that the stock was making a steady climb, indicating a successful promotion.

However, things seemed to have gone astray:

SECURITIES EXCHANGE ACT OF 1934

Release No. 70933 / November 25, 2013

The Securities and Exchange Commission ("Commission") announced the temporary

suspension, pursuant to Section 12(k) of the Securities Exchange Act of 1934 (the "Exchange Act"), of trading in the securities of Life Stem Genetics Inc. ("Life Stem"), of Beverly Hills, California, commencing at 9:30 a.m. EST on November 25, 2013, and terminating at 11:59 p.m. EST on December 9, 2013.

The Commission temporarily suspended trading in Life Stem because of questions regarding the adequacy and accuracy of information about Life Stem, including, among other things, its business operations.

_____ 

Oops!

Here is the chart, courtesy of those nice folks at Stockcharts.com:

Naturally, an aggressive, professional short seller will be happy to inform the regulators of the fruits of its research. 

However, this does not always work. In fact, it may be more often that it does not work. Regulators are overloaded and may not feel motivated to attack your particular stock. Companies fight back and will be ready to counter any presentation you may make. You may even be sued by the company for slander. 

Nonetheless, informing the regulators of a documented fraud is a good thing to do. It serves the public good and your pocketbook. There is little downside risk and the profit potential is enormous. 

Economic Shorts

There are two basic unannounced theories of short selling, or indeed long investing.

The first you might call cheap investing. The investor buys something that is under-priced. He is looking for a value, a cheap stock.

In this method, you run the risk of having false information from the company.

The second depends on predictions of the future, usually based on some economic analysis.

Now there is nothing wrong with economic analysis. I have nothing against those who struggle with inaccurate government reports, sudden surprises, unforeseen developments, and all the twists and turns of fate. However, somehow economists have developed a reputation for being mostly wrong, like long term weather forecasts.

The effects of losing your capital are so crippling that exposing it to the risks of economic forecasts is a very brave act that is well known to many hedge fund managers who have large losses.

There are just too many imponderables in the future to be betting your money on it.

Even when you buy $1 for fifty cents, you may find nasty surprises. There are investors who have purchased stock in a company at a price below the cash per share that is in the company, only to find that they still lose money.

However, these losses are very rare compared to the losses to those who predict the stock market or the economy.

We are often told that market timing is a losing game. In fact, it may be.

Now when you go short, you want to be shooting fish in a barrel, not stabbing blindly into the ocean.

The truly aggressive short seller is not content to take position and wait for the future to happen, he makes it happen.

At the least the short makes a big public announcement of his discovery so that the long holders will be stampeded out and new shorts may come in to assist.

He may go further than that and try to start government or media investigations, inform customers, employees, suppliers, sources of finance and those who assist the victim.

In doing so, he risks suits for slander, interference with business relations, and securities law claims.

A wise victim investigates the accusers and any dirt found may be used against the short.

So some shorts have developed the strategy of using fronts or attacking from a hidden position.

The allegation has been made that the people who were short mortgage securities for large profits financed various seemingly independent entities to expose mortgage problems.

So these are the three positions in the game, bet on the future, buy cheap, or make it happen.

Short Selling Bubble Stocks - Looking for weak holders

In the old pre-1929 days, the bears would find an overpriced stock and slam the bid hard, driving the stock down and causing the bulls to panic and sell out cheap.

In modern times, the bears would follow a stock up and when they felt it was vulnerable they would go gunning for the stops. The bulls would follow the trend up and put sell orders, stop loss orders, below the market to get out fast if the stock declined. Suspecting the presence of a large grouping of stop orders below the market, the bears would know the stock down through the price of the stop loss orders and then mop up cheap stock when that stock hit the market.

Many of the bulls used stock price charts and by drawing the same lines as the bulls, the bears knew where the bulls were likely to have their stops and went hunting accordingly.

In last few decades, one of the methods used was to find a bubble stock, usually a small cap manipulation, dig up and document the dirt using a private investigator, and give the dirt documents to financial columnists who released it while you blast the bid.

Then came the naked short sellers, shorting more than the outstanding stock and driving the company to oblivion.

Now we have blogs that release the results of their investigations.

Here is stock that just suffered from a negative research report, OMEX. See the drop from $3 down to almost $2.  The company has tried to invalidate all the alleged negatives, but so far without much result.

 Chart courtesy of Stockcharts.com

The bears, good predators as they are, look for signs of weakness.

If they see small public investors jumping in on an overpriced bubble, they know the stock can be driven down.

Recently, the Facebook IPO was done at a high price, the company put a ton of stock on the market at the last minute, and the small investor, aka "the public" was hot to get in on the deal.  Great opportunity for the shorts.

Chart courtesy of Stockcharts.com

When a stock drops that fast from the opening, it is hard to get anyone brave enough to fight the trend.

No doubt driving the stock down into the 20s caused a lot of small holders to sell.

That, is what the predatory shorts are looking for.  A large discrepancy between price and value, a bubble, caused  by small, timid public investors paying too much.

Institutional investors can be more brave, but they also can fear having a loser on their books when they have to report for the period and sell beforehand to avoid being embarrassed.

In fact, having a huge percentage of institutional investors in the stock in very often a sign of impending doom. if you see 85% of the stock owned by institutions, you have to suspect that they may be overdoing it and can be stampeded by bad news.

Look for weakness, but the basic pattern is to prey on the small investor who has been carried away with enthusiasm.

Shooting Fish in a Barrel - Shorting Penny Stock Promotions

The worst nightmare of the short seller is to take a position in an obviously overpriced stock only to find that the darn thing is actually a real company and it keeps growing, with the stock price going up continually.

They say that you can boil a frog if you raise the temperature in the pot slow enough. 

Well, the sensation you have as a short seller who has shorted a real high growth company is the sensation that the frog must have – you know that you are more and more uncomfortable, but the distress is not strong enough to get out until you suddenly realize that you have been boiled alive.

To avoid this distress, we look for stocks that can never make it, that have huge hidden issues like  undisclosed criminal convictions of the principals or worse.

The problem of shorting a real company that looks like a promotion will rarely if ever occur if you stick to shorting penny stocks.

Most penny stocks are unvarnished promotions with no merit.  Pump and dump penny stock promotions.

If there is any problems with these stocks, it is (1) you can never tell when the promoters will pull the plug so it is hard to pick the peak and (2) you might not be able to short enough.

As to not predicting the peak, that will limit your profit but not give you a loss. Most of these promotions will go to oblivion, so no matter where you shorted them, you will inevitably profit. The question is only how much.

The way penny stock promotions work is that the promoter gets control of a shell company or one with very little business. This can be a Form 10 shell, or a Footnote 32 shell, or just a nearly defunct company.

The promoter and his associates may buy aged debt – convertible debt that is old enoughto qualify under the Rule 144 holding period.

After that, cheap stock is issued to the promoter and his friends.

To set up the trading, a reverse split may dilute out the prior existing shareholders.

Then a sexy company is merged in the promoter starts developing the market in the stock. More and more promotion is introduced. This stage is called the “pump. When the promoter has had a chance to “dump” his stock, he will pull the plug and stop spending on promotion.

The stock will then crash for lack of new demand.

In your short position, you will find that you are helped by the market makers. 

They know which way the wind blows and will be shorting the stock on the way up and bear raiding the stock as it collapses. A well capitalized market maker will be licking his chops when he sees a rich penny stock promotion. He can just keep shorting all the way up, knowing that his whole position will be profitable eventually, whatever the price.

Usually, these penny stock promotions are wildly under-capitalized. Why spend money on developing your business when you can spend it on stock promotion? Selling stock is a lot more profitable than selling products.

I have seen $4 million spent on stock promotion (on which the promoters made $12 million reportedly) and less than $1 million was raised for the company. The company was lucky to get that. The stock, a former Form 10 company, started trading for real below 60 cents, hit over $2.20 and now, a year or so later is at three cents.

The company is not always to blame. In this case, it was the reverse merger promoters who took advantage of a legitimate start up effort.

Now consider, there was enough volume out there on this one to sell $12 million in stock from 60 cents up to $2.20 and now you can buy it back at three cents -- about a one year round trip. 

Does that roughly 97% profit in a year with little risk that the stock will go higher sound like it might be of interest?