Penny stocks have a high level of risk and the possibility for above-average gains, so investing in them should be done with prudence.
Few full-service brokerages even sell penny stocks to their clients because of the inherent dangers. Many are shares in firms on the verge of bankruptcy, small or new businesses with little or no following, or debt-ridden companies.
There are two methods to profit from penny stocks, both of which are high-risk investments. Take a look at what penny stocks are.
The Insider’s Guide to Penny Stocks:
Penny stocks are commonly characterized as equities that trade for less than $1 per share. Others describe them as equities with a market capitalization of less than $5. Penny stocks (or microcap stocks) have a market capitalization of less than $250 million, according to the Securities and Exchange Commission (SEC).
Penny stocks are often traded on the Pink Sheets or the OTC Bulletin Board (OTCBB). Both interactions should be handled with extreme caution. This is especially true for the Pink Sheets because, unlike OTCBB stocks, corporations trading on them are not required to file with the SEC.
Even for trading on the OTCBB, don’t get your expectations up. It’s tough to reach a reasonable conclusion about whether or not the firm can survive, let alone grow, without further data. It’s important to remember that there are no minimum requirements for a firm to be on the Pink Sheets or the OTCBB.
Penny stock con artists make a living by duping naïve investors into investing in worthless businesses and stealing their funds. It would help if you stayed away from an extensive list of widespread penny stock frauds
Pump-and-Dump Arrangements:
This type of deception occurs frequently. Promoters pique people’s interest in a firm that isn’t well-known or unknown. Inexperienced investors purchase the stock, causing the price to rise. The wrong people sell or dump the stock at a significant profit after reaching a particular inflated level. Investors are left out in the cold.
Pump-and-dump tactics are frequently advertised in free penny stock newsletters. These canines are promoted by the publisher, the writer, or both.
Read the small print on a penny stock newsletter’s website if you receive one. It might reveal a financial connection to stock promoters.
Scams that are short-and-distort:
The pump-and-dump method is the polar opposite of this. The con artists use Short-selling in this instance to generate a profit. An investor who sells short is wagering that the price of a stock will decline. Shorting is a method in which an investor borrows shares from a broker and then sells them on the open market.
If the stock’s price decreases, the short seller buys it cheaper. The borrowed shares are returned to the lender, and the short-seller pockets the difference in profit. Short-selling a stock and then spreading false and detrimental rumours about the firm is how penny stock fraudsters work. Short-sellers make money while investors retain a losing stock.
Deceptions About Reverse Mergers:
A private firm may combine with a publicly traded corporation to become publicly traded without the time and expense of using standard listing techniques. This makes it simple for the private firm to raise its stock price by falsifying its results.
While some reverse mergers are legitimate, you may recognize one by looking at the company’s history and looking for irregularities in the transaction.
Scams in the Mining Industry:
Gold, diamonds, and oil have always been enticing, and mining frauds can be traced to the dawn of time.
Bre-X, which took place in the mid-1990s, was one of the most well-known mining schemes. David Walsh, the firm’s founder, erroneously stated that his company had discovered a large gold mine in Burma. Speculation increased, and by 1997, the company’s worth, based entirely on penny stocks, had risen to $4.4 billion. Most investors lost everything when the firm went bankrupt.
Guru Rip-Off:
A guru might be anyone who has a marketing budget. Unfortunately, they frequently develop a cult-like following.
This form of deceptive advertising claims to offer a specific secret that the financial expert utilized to purchase a lakeside house and a high-end automobile—the expert pledges to reveal his penny stock trading secrets for a one-time nominal fee.
That email or envelope should be thrown away. There is no such thing as a one-size-fits-all formula for success in the stock market.
Also, stay away from pitches from anyone claiming to be the next Thomas Edison and offer you the chance to invest in the next great thing after the lightbulb.
The No-Net-Sale Scam:
The con artists sell stock shares with the restriction that they cannot be resold for a set time. This stock, according to the investors, is in high demand.
The investors are left with nothing by the time the SEC gets around to shutting down these schemes.
Rackets for Offshore Play:
Companies that operate outside the US do not register their shares in the US when selling to US investors. Penny stock con artists enjoy it.
They purchase unregistered foreign firm shares for a low price and then sell them to investors at a higher price. The company’s stock price fell due to the flood of unregistered shares. The criminals’ profit, while American investors receive little or no return.
How to Stay Away from Scams:
Market manipulation, fraud, and deception abound in the penny stock business. As the infamous incidents of Enron and WorldCom demonstrate, such unethical methods aren’t limited to penny stocks and micro-caps.
However, how can you prevent being duped by unscrupulous penny stock marketers looking to make a quick buck? Some ideas are listed below.
Research vs Promotion
Promoters hire newsletter writers to produce glowing stories about their stocks. They use exaggeration, unrealistic forecasts, and, in some cases, purposeful misrepresentation to build a persuasive argument for investing in bad penny stocks.
One option is to look at the disclosures section after the report to check whether the writer is getting paid directly by the firm they’re recommending, usually a mix of cash and shares.
This is advertising, not a research report if that is the case. Although a penny stock firm is unlikely to have Steve Jobs at the helm, you may still look at management’s track record. Find out whether the company’s leaders and directors have any significant successes or failures or if they even have any relevant expertise.
Assess the Financial Situation:
Although penny stock businesses seldom provide detailed financial information, it’s never a bad idea to double-check the financial statements they do disclose.
Examine the balance sheet to check if the firm owes any significant debt or has any important obligations, as well as the amount of net cash on hand. It’s a good indicator if the income statement indicates a significant increase in revenues recently.
Be aware of the level of transparency.
The greater the amount of information provided by the firm, the better. It denotes a higher level of corporate accountability.
The OTC Markets Group, for example, separates its securities into three tiers: OTCQX (the highest tier), OTCQB (middle tier), and OTC Pink (lowest tier) (bottom deck). The integrity of a company’s operations, its level of disclosure, and its level of investor interaction are all factors that go into these categories.
Because OTC Pink firm reporting can be inconsistent, OTC Markets Group divides the group into three categories: current information, limited information, and no information, based on the quality and quantity of data.
Signs to Look Out For:
Investing in a firm with little or no information is a bad idea.
Furthermore, the equities for which OTC Markets Group recommends that investors take extra caution and due diligence usually display a skull-and-crossbones Caveat Emptor symbol.
Penny stocks can get this symbol for various reasons: the firm or its insiders may be under investigation for fraudulent or illegal behaviour, or the company may be engaged in questionable advertising efforts such as spam mailings.
Is the Business Plan Realistic?
Investors should consider whether its business plan is feasible and whether it has the asset base it claims. Remember the infamous Bre-X case from earlier? In Busang, Indonesia, a Canadian exploration firm claimed to have discovered one of the world’s largest gold mines.
The entire tale turned out to be a massive hoax. The bre-X stock soared from 12 cents to $280 before the news broke. Its demise in 1997 resulted in a market value loss of 3 billion Canadian dollars.
How to Invest in Penny Stocks:
It’s critical to determine whether the stock has room to grow. Isn’t it true that you’re investing to make a profit? As a result, you should assess whether the penny stock you’re contemplating has true upside potential or if it appears to be more of a flavour-of-the-day stock, such as a corporation seeking to cash in on the newest investing trend.
There are four rules to follow:
Even if you’re investing a modest amount of money, you should create a realistic risk-reward evaluation for the stock.
1. Diversify and limit your holdings:
Even if you’re enthused about the potential for your favourite penny stock, you should still take precautions. Minimize your stock holdings to no more than 1 per cent or 2 per cent of your whole portfolio to limit your losses. It’s also a good idea to diversify your penny stock portfolio, which should make up no more than 5% to 10% of your whole portfolio, depending on your risk tolerance.
2. Examine trade volumes and liquidity:
Even if you’ve made a profitable penny stock purchase, you’ll want to sell your stock at some point. To trade efficiently, the store should have sufficient liquidity and trading volumes. Otherwise, you risk having a large bid-ask spread, making it extremely hard to turn your theoretical profit into a real one.
3. Recognize when it’s time to sell:
A penny stock is seldom a long-term buy-and-hold investment. Short-term trading is the foundation of the industry. If you make a significant profit in a short period, book it immediately rather than waiting for more considerable earnings that may never come.
4. Look for high-quality stocks to invest in:
Ventures founded by experienced management who have successfully departed a previous firm and equities with potential biotechnology or natural resource results are all good bets. There are fallen angels as well. These once-famous firms have fallen on hard times but can recover. After the 2000-2002 “tech disaster,” several of today’s prominent technology firms were selling in the low single digits, while household brands like La-Z-Boy Inc. (LZB) were trading for less than a buck in March 2009.