Legend has it that a dodgy day trader once made a huge profit by faking a confidential takeover report on one of his stocks and strategically losing it in coffee shops across the City. The ensuing buying frenzy sent the company’s share price skywards, at which point the trader sold.

Now a new generation of fraudsters is exploiting the mass-marketing potential of spam e-mail to conduct a similar swindle against unsuspecting private investors.

The fraudsters send out hundreds of thousands of e-mails recommending a particular company, usually an obscure American stock with low liquidity that is sold over the counter or through an online broker. The messages often claim to offer inside information about an imminent announcement that will boost the shares and implore recipients to buy quickly or miss out.

Sophos, the internet security company, says that e-mails falsely hyping stocks now account for 15 per cent of all daily spam, up from 0.8 per cent in January last year. Graham Cluley, senior tech-nology consultant at Sophos, says: “The increasing quantity and sophistication of these pump-and-dump campaigns suggests that there is plenty of money to be made.”

The fraudsters make a profit by purchasing the stock cheaply before the spamming campaign starts and selling as the demand created by their promotion drives the price higher. The spammers target low-volume stocks because small amounts of investment activity can generate large fluctuations in price.

As the spamming campaign stops, the value of the shares falls quickly, often leaving investors who bought the stock with heavy losses. The high transaction costs of trading in over-the-counter stocks amplify the losses. In many cases, the stock is issued by a legitimate business and the company’s executives are unaware of the fraud until it is too late. But in other cases, the company is involved and its executives have commissioned the spammer to drive up its share price for personal gain.

Jonathan Zittrain, Professor of Internet Governance and Regulation at Oxford University, conducted a study on more than 300 pump-and-dump e-mails and found that, on average, a promoted stock gained almost 12 per cent in the five days up to the peak day of spam before falling back almost 6 per cent in the following three days.

In some cases, the price fluctuations can be much greater. Separate research by Sophos found that the share price of Southern Cosmetics, an American penny stock that was subject to a spamming campaign in June, jumped from 1 cent to 6 cents in just two days before falling back sharply. This week, Southern Cosmetics was trading at 1.7 cents, a fall of 350 per cent from its peak.

Professor Zittrain says that the increased liquidity created by higher volume is crucial to the success of the spammers’ pump-and-dump strategy. “Without greater liquidity, the fraudsters’ sell orders would depress prices so much that they would realise little, if any, profit. The spammers choose American stocks because they are the easiest to buy for people in different countries.

“Few victims come forward because they are too embarrassed, but there are many out there. The more successful spammers can make millions of dollars. The perpetrators are often bored teenagers who are financially and technologically astute.” He points to the case of Jonathan Lebed, a 15-year-old who made hundreds of thousands of dollars using internet chat rooms, such as Yahoo! Finance, to hype penny stocks that he had bought.

The Securities and Exchange Commission (SEC), America’s financial watchdog, prosecuted Lebed for failing to disclose an interest in the shares he was promoting. In an out-of-court settlement, Lebed agreed to pay $285,000 (£150,900), which is thought to be significantly less than he earned from the scam. Lebed now claims to have gone legitimate and runs his own stock-picking website.

John Stark, the chief of the Office of Internet Enforcement at the SEC, says that his department has prosecuted hundreds of spammers, many under 20 years of age. He says: “While the internet makes it easier to commit this type of fraud, the electronic footprint and share-trading record provide an evidential trail that I can show to a judge. In many cases the perpetrators are easy to catch and end up in jail.”

The UK Financial Services Authority (FSA) says that, so far, pump-and-dump spammers have not targeted UK stocks, although British investors have fallen victim to the scam. Eleanor Hughes, an FSA spokeswoman, says: “Pump-and-dump spammers are usually based outside the UK so our powers are limited.

“Investors should treat with suspicion e-mails that claim to share ‘privileged’ information. The same goes for postings on internet message boards. Fraudsters can only influence share prices if people respond to their tipping.”

There's such a lot of it about

• Some experts estimate that up to 14.5 billion spam messages are sent every day
• Spam accounts for about 80 per cent of all e-mail traffic, up from only 8 per cent in 2001
• More than 1.2 million pump-and-dump e-mails have been reported to the Securities and Exchange Commission (SEC) this year
• The SEC has started 517 prosecutions for pump-and-dump frauds in the past ten years

  For more investment articles visit www.timesonline.co.uk/invest