Investors and traders may be easily tempted by the low prices and sharp price movements of penny stocks, but don’t fall victim to the Pump and Dump scheme and other major risks of penny stock investing. Here’s what you need to know to stay safe.
“Penny stocks” have a low share price of typically less than $1 (up to about $5). New investors are easily attracted to penny stocks because they can purchase a large number of shares for a low amount of money.
Since many mainstream stocks trade for more than $100 per share, an investor with only $300 to invest may prefer to buy a bunch of penny stocks, rather than only 1 or 2 shares of a stock with a much higher price.
Investors (and gamblers) are also drawn to penny stocks because of the perceived opportunity to make huge percentage gains in a short period of time. Penny stocks can be extremely volatile from day to day, enabling investors to literally double their money overnight if a stock trading at $0.10 per share jumps to $0.20 the next day.
The low share price and ability to reap massive gains in a short time is definitely appealing on the surface–but don’t be fooled! In most cases, buying penny stocks is merely a ticket to quickly losing your hard-earned money.
Continue reading to find out about the extreme dangers of investing in penny stocks, especially how to detect and avoid the devious Pump and Dump scheme.
3 Dangers of Investing in Penny Stocks
- Penny stocks are known as pink sheets because they are traded over-the-counter via a broker-dealer network, rather than a centralized exchange. Unlike companies listed on major exchanges such as the New York Stock Exchange (NYSE) or NASDAQ, penny stocks do not meet the requirements to be listed on a standard market exchange. As such, penny stocks are not regulated nearly as tightly as stocks listed on a centralized stock exchange. Since the companies behind penny stocks are not held to the same financial reporting requirements as major companies, there is often a lack of legitimate financial information to determine whether the stock is a good investment.
- Penny stocks trade less frequently than stocks listed on a public exchange because they are bought and sold over-the-counter. This lower liquidity means you may be challenging to find a buyer for your penny stocks when you are ready to sell them. Even after finding a buyer, you may be forced to sell at a lower than expected price due to low liquidity.
- The greatest danger of investing in penny stocks is the frequent occurrence of illegal “Pump and Dump” schemes. A Pump and Dump occurs when an investor or group of investors heavily promote a stock they are holding, then sell immediately after the stock price has risen due to the initial interest in the promotion. The investor(s) behind the hype walks away with a big gain by selling into strength. However, the unsuspecting investor who bought the promoted stock is now left holding a losing stock that has fallen in price due to this unethical and illegal act. Since the Pump and Dump scam is so prevalent in the world of penny stocks, let’s dive in deeper for a closer look at how it works.
A Closer Look at the Pump and Dump
A Pump and Dump scam typically starts when a penny stock is promoted as a “hot tip” or “the next big thing,” along with hyped details of an upcoming news announcement that will “send the stock through the roof.” Think about The Wolf Of Wall Street movie and you got the right idea.
The promotion is usually done through a combination of email, social media, and other types of internet marketing. There are even subscription-based websites focused on trading penny stocks that may be designed to entice unsuspecting investors.
The exact details of each individual P&D may be different each time, but is always tied to artificially shifting supply and demand to affect the stock price.
As mentioned earlier, the P&D scam is normally restricted to “pink sheets” that are traded over-the-counter, as stocks traded on a central exchange are much more highly regulated.
Remember that penny stocks (“pink sheets”) are typically highly illiquid. As such, they are immediately susceptible to sharp price movements when volume increases.
Through heavy and targeted promotion, the group behind the scam increases the demand and volume in the stock, which leads to a sharp rise in the price. After the price has risen, the group will sell their position to make a large short-term gain.
Real Example of a Pump and Dump Scam
Let’s look at an actual example of a past P&D to pull it all together. No two P&D scams are exactly the same, but all follow a similar path to what is detailed below.
During the summer month of August, a P&D scheme was initiated by using a devious “wrong number” scam. Thousands of random phone calls were made to victims across the USA. A message was left on victims’ voicemails that talked about a hot “can’t lose” stock tip. The message was delivered in a way that made the victim think the message was accidental and intended for someone else.
On the chart above, notice the price of the stock rose from around $0.30 in mid-August to nearly $1.00, a massive increase of 300% in just a one-week period.
On the bottom of the chart, notice trading volume also dramatically surged in sync with the price gain. The average daily volume rocketed from less than 200,000 shares to nearly 1 million shares on several days.
Unsuspecting investors seeing the increased interest in the stock would have bought into the stock as it approached $1.00–only for the price to plunge 80% to around $0.20 a few months later.
Cheap Stocks Are Cheap for a Reason!
With a low share price and the lure of huge percentage gains, it is easy to understand the temptation to “invest” in penny stocks.
However, your best chance of making money in the stock market is to stick with well-established, exchange-listed stocks with a solid history of earnings growth (the type of stocks traded in The Wagner Daily newsletter).
If a legitimate company truly has strong fundamentals with a promising outlook for growth, serious institutional investors will already be buying the stock and driving the price higher.
As such, the best stocks to invest in are usually not cheap–they are often the most expensive! Likewise, cheap stocks are cheap for a good reason–the “smart money” investors are not buying them.
Always remember the investment mantra you may have heard over the years: “If it seems too good to be true, it probably is.” If you receive a “hot” stock pick from a stranger, take a moment to think about why someone you don’t know would be so willing to give you such information.
Although it is technically possible to make a huge return on your investment in a short period of time, you must realize it is statistically not likely to happen.
Stay away from penny stocks or you will regret your decision many times over. Keep the odds of investment success in your favor by always doing your own research. This will help you avoid getting duped by the notorious and devious Pump and Dump scheme.