The Psychology of Pump-and-Dump Schemes

Pump and dump schemes had been very common in the cryptocurrency market in the past three years and unfortunately, some people had been caught on the wrong side (buying when the price slumped or short selling when it continued to edge higher). The main reason why that happens has to do with the level of understanding of the price action context as well as how the other market participants are investing their money.

How to spot a pump and dump?

To spot such a situation, one should look after several important clues:

• A cryptocurrency that rises impulsively without any fundamental change justifying the rising value.
• Above-average daily/weekly/monthly gains.
• Price action moving parabolically higher.
• Exuberance in the press about the token.

If these conditions are met, then you’re very likely dealing with a potential pump and dump scheme. It’s important to note that these situations don’t happen in large-cap tokens like Bitcoin or Ethereum. Small altcoins where liquidity is very low is where the perfect conditions are for pumping the price up to and trapping people who were late at the party.

Dealing with such market conditions

One of the most important aspects when dealing with a price pump has to do with the psychology of the trader/investor. FOMO reactions could result in heavy losses in the long run, but that does not mean we can’t find good opportunities in these situations. On the contrary, the volatility is very high and thus trading opportunities will arise both on an intra-day and longer-term.

The first thing you need to do is not fall into the exuberance of the market. Secondly, you must find critical support/resistance areas and trade on the breakouts. That’s when a lot of new players will enter the market. At the same time, you should not forget that those price gains are not justified and at some point, the price will reverse.

Generally, the price will overshoot on the upside, resulting in an exhaustion pattern or climax. To spot exhaustion, one can look at the price and use a candlestick chart, for example. A long series of large candles occurring at the end of an already-established trend, or a series of candles growing bigger and bigger, as well as diminishing gradually in size, will suggest the buying power is drying out.

Even though cryptocurrency investors allocate capital differently in 2020, we’ve already seen many pumps and dumps in coins like Bitcoin SV, and more recently in Cardano and Chainlink. The last two are still at elevated levels, and the dump has not yet accelerated.