Last Updated on 3 November, 2022 by Samuelsson
As a general rule, most reputable investors avoid having penny stocks as their main focus. However, many traders often wonder whether they can have better returns if they invest in them. On the other side, there have been many scams regarding penny stocks too which often make investors unsure whether or not penny stocks are a scam.
While penny stocks themselves are not a scam, there have been numerous scams run by shady organizations using penny stocks. Penny stocks are often used to scam money off of inexperienced investors using a number of methods. As such, you should exercise extreme caution whenever trading a penny stock.
What Are Penny Stocks?
Contrary to the popular belief, a penny stock is any stock trading at less than $5, not $1. Simply put, penny stocks are stocks of a company that does not have enough capital to list themselves on a reputable exchange.
Penny stocks are traded either on FINRA’s OTC Bulletin Board or Pink Sheets. The companies that are traded on the pink sheets are not required by the SEC to file any documents. In general, it is very difficult to find all the information necessary in order to trade a penny stock.
There are probably a fair number of penny stocks currently in the market that could yield a huge profit for their investors. However, the reverse is also true. A large number of penny stocks are companies with an exorbitant amount of debt or companies that have very little business prospects.
Due to their mysterious nature, penny stocks are perfect for scammers. Remember that penny stocks, in themselves, are not a scam, meaning that it is possible for a penny stock to present a worthwhile investment opportunity. However, it is very easy for scammers to take advantage of people with limited financial knowledge through the use of penny stocks.
Here is further reading that might be of interest.
Common Penny Stocks Scams
Occasionally, it can be very difficult to determine if you are being scammed when purchasing a penny stock. However, most of the penny stocks scams have been around for a long time and are fairly easy to identify. Here are some of the most common ones.
This has become increasingly common in the social media age. If you frequent trading websites, you are bound to see ads which teach you ‘the winning formula’. While those who are experienced investors generally know that there isn’t a single formula that could help you make money, new investors often fall to scams such as this.
When it comes to penny stocks, people are often lured into scams because the return on investment of a successful penny stock is much greater than that of a listed stock (on average). These ‘gurus’ offer a quick way to make money by teaching you how to trade penny stocks.
Most of the scammers who use this tactic often demand an upfront payment. Usually, the secret formula is disguised as a ‘course’ that you can complete. Also, these courses are almost always on sale. Usually, the list price is very high such as $2000, but you can get it on sale for as low as $200 today. Products such as these are almost always on sale, despite being advertised as a ‘limited time offer’.
Remember that while this scam is more common among penny stocks, it is also quite prevalent in other forms of trading. It is always better to only learn from proven traders and hone your skills by actually trading in the markets.
Pump and Dump
This is by far the most common penny stocks scam. The film Wolf of Wall Street starring Leonardo Dicaprio shows the main character extensively using pump and dump schemes to take money from their clients.
In a pump and dump scheme, the price of a stock is pushed up through a number of ways. One of the simplest ones is through endless promotion which causes potential investors to take note of the stock. Due to the promotion, the price of the stock rises. Once the price of the penny stock is high enough, the scammers sell their shares and stop the promotion, causing the shares to plummet in value.
In the case of Jordan Belfort (upon which the aforementioned film is based), his brokerage firm bought penny stocks and then encouraged its clients to purchase them too. This caused a rise in their price due to an influx in demand. Later on, the firm sold its shares (held through proxies) for a handsome profit while the clients suffered.
Dump and Dilute
This is a scam that is run by the company itself. In essence, the company continues to issue shares for no apparent reason. This is done so as to raise money from investors. The money is then paid out to the perpetrators of the scheme rather than spent on the company itself.
Often times, companies engaged in this scheme reverse-split their stock. Investors hand in multiple shares and receive one in return. This is done so that the number of shares remains relatively small. This way, inexperienced investors can be deceived if they do not properly research the penny stock. As such, this scam is fairly common among companies with no viable business model.
Why Invest in Penny Stocks?
While the scams listed above are the most common ones, there are numerous other scams involving penny stocks as well. This may cause some people to question why invest in penny stocks in the first place?
The main reason is that a good investment in penny stocks will yield a lot of profit. If you do manage to find a hidden gem in the shady world of penny stocks, it is possible for you to achieve returns simply unheard of in the stock exchanges.
That said, these stocks are few and far between. Let us briefly take you through the proper way to invest in penny stocks.
How to Invest in Penny Stocks?
Due to their low volatility, you often cannot day trade penny stocks efficiently. As such, you have to rely on fundamentals and invest in companies where you see growth potential. If you want to invest in penny stocks, remember that you will need to think long-term.
First, find out everything that you can about the company that you are planning to invest in. If there isn’t enough information available, avoid the company at all costs. Companies shrouded in mystery are the ones involved in scams most of the time.
After you have collected all the data, you should think of penny stocks just like you would think of stocks listed on an exchange. Try to determine if the company has viable future prospects and all the risks associated with investing in that particular company. Take a look at the management as well as previous financial performance to make sure that investing in the said company is a good idea.
Due to the extremely risky nature of penny stocks, it is advised that you do not invest a lot of your capital in them. The vast majority of your capital should be held in securities whose future price is easier to predict. On top of this, holding stocks listed on an exchange is generally the best option since it is much easier to find buyers in case you want to liquidate your positions.
Most penny stocks are not scams. However, the world of penny stocks is a prime hunting ground for scammers looking to make a quick profit. Inexperienced investors are usually the main targets of such scams. However, any investor who does his/her research should be able to separate the scams from the investment opportunities.
If you do invest in penny stocks, exercise caution and only risk a small amount of your capital on them. Investing in penny stocks is not that different from stocks listed on an exchange once you weed out the frauds. Try to find good companies with a solid history and invest only if you are reasonably sure that they will experience growth!