Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

The Lowdown on Penny Stocks

Think penny stocks will make you rich? If you don't understand the risks, you could end up penniless.

Penny stocks are highly speculative and risky. In fact, many brokerages don't cover them simply because they are so difficult to track and predict.

Still, penny stocks have the potential to make huge profits, as well as huge losses. This can scare off most investors who are looking for a more stable income with good steady capital growth. But if you have the nerve and know how penny stocks work, then perhaps better than any other type of investment penny stocks have the ability to make you very rich, very quickly.

But get it wrong and you could lose your entire investment. Since there are a number of opinions as to what share price determines a penny stock, some brokers refer to them as stocks that trade for less than $1, while others set the cut off price at $3, and still others at $5.

However, the Securities Exchange Commission (SEC) has defined penny stocks as low price stocks of small companies generally trading under $5. While most penny stocks trade on the OTC Bulletin Board and Pink Sheets, some trade on the major exchanges. Many also trade on foreign stock exchanges.

Penny stocks became popular around the 1940s to 1950s when shares of uranium mining companies were bought and sold literally over the counter in a coffee shop in Salt Lake City. As a result of these unregulated markets, a large number of companies sprang up around that time promising investors huge returns if they invested in their penny stocks.

By the 1980s, penny stock fraud began to take place primarily from Salt Lake City, Denver, Spokane and Boca Raton. Companies that were not backed by any assets, earnings or employees, began changing hands as investors were promised their pot of gold at the end of the rainbow. Several companies launched initial public offerings (IPO) at low prices, so that they were saved the bother of filing information with the SEC. Though some of these stocks did go on to yield returns to their initial investors, most of them proved to be bogus shares, with no trace of the company after the IPO was completed.

Despite the history of penny stock scams, many new investors are still intrigued by the appeal of these stocks due to their low price and potential for rapid growth. Many penny stocks are new firms and some will do well and even graduate from the Pink Sheets and the OTCBB to one of the larger trading venues. However, the failure rate is high and many penny stocks eventually become worthless when the company goes out of business.

To illustrate how a large swing in price could occur, say that a small biotechnology company makes a discovery that may potentially be of use to the big pharmaceutical corporations. As a result, the penny stock may climb from a few cents to dollars a share.  However, the potential is always there for the stock to go south just as quickly. For example, let’s say the same company believes they have made a great discovery and attempts to get a patent only to find out that another company beat them to it. The setback causes investor confidence to plummet, prompting everyone to sell and the price drops below the original level.

Because penny stocks attract speculators, sudden surges in volume can often result in large price changes, thus causing these stocks to be volatile. Sometimes, a penny stock can surge several hundred percent in a matter of a few days. Similarly, severe loss can occur just as quickly. What’s more, a lack of liquidity can make it extremely difficult to sell a penny stock, especially if there are no buyers that day. Consequently, lack of liquidity and volatility also make penny stocks much more vulnerable to manipulation.

The SEC has warned that a good deal of this manipulation often takes place on Internet message boards, where fraudsters claiming to be unbiased investors who've carefully done their due diligence may in fact be company insiders. Either a single person or a group of people working in concert can create the appearance of a huge interest in a stock simply by creating a huge number of aliases, while preventing the most vocal or perceptive critics of these offerings from countering their false claims. As a result, you must always question overstated reports about a company's prospects.

To avoid being scammed by a bogus penny stock investment, here are some other warning signs that you should look out for:

•    Be aware of the hot stock tip that you receive by phone or email guaranteeing fantastic returns on your penny stock investment. Chances are you’re being scammed by a boiler room operation. Hang up the phone or delete the email.

•    There is a lack of financial information available to the public concerning penny stocks, since a large number of them are not required to file their financial information with the SEC. When you invest in a company, you want to know what you’re buying.

•    Be wary of companies that constantly issue statements highlighting the latest developments but provide no details on how those developments will help increase revenue or profits.

•    Low daily trading volume can make it difficult for an investor to enter and exit at a good price.

•    Make sure you’re dealing with a reputable broker. Many penny stocks are traded by only a single brokerage firm that has acquired a large number of shares at a low price. This firm, or a small group of firms working together, can work to create artificial demand for the stock through marketing practices that bring enough attention to the stock to drive up the price. The artificially high price will plummet after the firm sells its shares.

If you’re interested in penny stocks, the major exchanges are the safest and best places to find penny stocks. Companies listed on these trading venues have regimented reporting requirements, and must keep in compliance with those requirements to maintain their listing. Many of the companies are also followed by a number of news and quote services.

Before you invest in a penny stock, consult a financial investor to determine if penny stocks are the right type of investment for you. Take your time, do your research, and ask questions. If you’re still not sure, keep your checkbook closed.