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Why You Must Trade Cautiously When Investing In Penny Stocks

Are you ready to invest in penny stocks? Well, you’re about to take a big risk. Most often, these kinds of stock come with numerous risks including the lack of transparency as a greater possibility of loss. Plus, they’re typically offered by small companies and cost below $5 per share. High price volatility plus low liquidity are other common risks.

So, What Are Penny Stocks?

Penny stocks are usually categorized as those that trade for less than USD 5 per share and have a relatively small market capitalization. According to Fidelity, a penny stock transaction is a security traded below $3 and at a quantity higher than 10,000. Some investors also describe penny stocks as those that trade for less than $1 or over the counter on OTC’s Bulletin Board.

Most people assume that penny stocks are those that trade for less than $1. Nonetheless, the SEC classifies penny stocks as those stocks trading for as low as $5. Penny stocks usually trade on FINRA’s OTC Bulletin Board or the Pink Sheets. Both exchanges should always be approached with extra caution. Don’t get your hopes so high with stocks trading on the Pink Sheets or OTCBB since it’s difficult to access information to formulate a comprehensive conclusion regarding the company’s survival on the market.

Bear in mind that there aren’t any minimum standards for a firm to remain on the OTCBB and the Pink Sheets. Penny stock scammers have a tendency to lure inexperienced investors into purchasing cheap and worthless stock. So, be careful not to full prey into such traps that’ll only make you lose lots of money.

The Downside Of Penny Stock Risks

Though penny stocks are often associated with inherent risks, they have got the potential to bring you above-average returns. Nonetheless, investing in these products demands care and caution. Typically, penny stocks are the shares of companies that are headed to bankruptcy or small firms with little following. That’s why it’s always very important to understand the risks associated with penny stocks in order to make the right business decisions.

 Low Liquidity

Low liquidity is one of the major risks that come with penny stocks. Most penny stocks are thinly traded, with minimal shares traded each day. So, when selling or purchasing a stock with low trading volume, investors might not have the freedom to do so at their preferred time and price, something which can end up being costly in the long run.  Low liquidity is a major contributor to potentially high bid-ask spreads for most penny stocks.

There are several ways through which you can make profits with penny stocks, but it’s important to note that they are both high-risk strategies.

Pump-and-Dump Schemes

This type of fraud happens all the time. Here, promoters mobilize significant interests in less known or unknown stock. New investors purchase the share, pumping the price. After reaching a certain inflated price, the bad guys dump the stock at a higher profit. On the other hand, investors are left high and dry. The pump-and-dump strategies are usually distributed via free penny stock newsletters. The publisher is often paid to list these unattractive and hyped-up stocks. You might even notice that the business institutions or promoters are paying the newsletter’s author to feature them.

Reverse Merger Frauds

In some cases, private companies merge themselves with public companies, so they can become publicly traded without having to incur the expense of going through more conventional methods. And this makes it easier for the private firm to falsify its earnings as well as inflate its stock prices. Whilst certain reverse merges are legitimate, you can trace a reverse merger by carefully reviewing the company’s history and detecting fishy activities in its merger.

Short-and-Distort Deceptions

With this strategy, scammers utilize short-sell to accumulate a profit. Shorting works well when the investor borrows some shares and instantly sells them in the open market, but at a higher price. They always do so while hoping that the firm’s stock falls so that they can later buy back the shares at a lower cost. They then give back the shares to the lender and remain with a profit. Typically, penny stock scammers short-sell given stocks and ensure the stocks fall by spreading negative rumors about the company. Potential investors hold a losing stock, whilst short-sellers make huge amounts of money via their short-selling trick.

Offshore Rackets

The SEC claims that business institutions that operate outside the USA don’t need to register their shares whenever they’re selling to foreign investors. And this is what penny stock scammers love most. They purchase unregistered as well as cheap company shares from offshore locations and sell them to American-based investors at an inflated price. The influx of such unregistered shares causes the firm’s stock price to drop. Scammers end up making huge amounts of money, while investors are left with nothing to pocket.

 ‘No Net Sales’ Scam

This refers to a situation where scammers sell a company’s shares, claiming that the investors won’t be selling the shares for a given period of time. And investors get convinced to purchase the shares since they’re folded into believing there’s a huge and ongoing demand for this type of stock. Before the SEC (Securities &Exchange Commission) can even shutter these firms, investors will have lost everything.

How to Avoid Penny Stock Frauds

The penny stock market is full of manipulation, chicanery, and fraud. So, it’s important to exercise caution while conducting this type of trading. Check out the following tips and trade like a pro!

  • Grade the quality of the company’s management

  • Check-out promotion details and conduct extensive research

  • Evaluate the financials

  •  Understand the quality of disclosure

The Bottom Line

Though penny stocks are relatively cheap to purchase, they tend to pose numerous risks to investors. With the right tips, however, you still can maneuver through the manipulative world of penny stocks. But, it’s essential to understand all the risks involved with this form of business, so as to craft unique ways of dealing with the situation.

About RJ Frometa

Head Honcho, Editor in Chief and writer here on VENTS. I don't like walking on the beach, but I love playing the guitar and geeking out about music. I am also a movie maniac and 6 hours sleeper.

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