Penny stocks are the stuff that investing legends are made of. Nearly every story involving an investor achieving astounding gains – as well as astounding losses – involve trading penny stocks. Long considered to be the most volatile security you can invest in, penny stocks can be tempting due to their allure of spectacular profits, and the possibility of becoming an overnight millionaire.
One of the first things you learn when beginning to invest is that reward is proportional to risk. The higher the risk involved in an investment, the greater the potential gains. The flip side of that coin is the very real possibility that you could lose some or even all of your investment. The risk of losing 100% of your investment is stark reminder that investing in penny stocks is not for everyone, and requires careful consideration.
When you invest in penny stocks, you absolutely must have a plan prior to making any type of purchase, and this plan must contain an exit strategy. Without either of these things you add unnecessary risk factors to an enterprise that is already risky enough. The idea is to lessen the risks involved, not enhance them.
What Are Penny Stocks?
There are many definitions of penny stocks. The one given by the SEC is any stock priced at less than $5. Other definitions include stocks priced at less than a $1 and less than $2. Some traders associate penny stocks as any stock that is not traded on any of the major stock exchanges, for example AMEX and NYSE.
Whatever definition you use they are essentially stocks that are much cheaper to buy than average. It is always a good idea to find out what your broker considers a penny stock. Many brokers have various fees associated with investing in penny stocks, and some do not allow them to be traded at all. Find out what your brokers policies are before investing, and save yourself from unpleasant surprises.
Penny stocks are usually highly volatile and risky. They are generally only suitable for traders with a very high appetite for risk. Spreads on penny stocks can also be very large, providing an extra hurdle for the trader to overcome. Make sure you are being honest with yourself as to how much risk you really can handle.
Penny Stock Fraud
You may be aware, penny stocks are often considerably less liquid than more expensive stocks. This can make them relatively easy to manipulate. There are many fraudulent schemes aimed at effectively stealing your money. Popular ones include:
Pump and Dump
A pump and dump fraud is where an individual or a group of criminal speculators buy a particular stock so the price rises. They then release false information as to why the stock has risen. They try to spread their rumor as widely as they can so as many people as possible buy the stock. When the price has risen considerably after people believing the rumor and buying the stock. The criminals then sell the stock for a huge profit. All the other traders who bought the stock end up losing money when the price crashes back down. The later a trader bought the stock, the more they generally lose.
The opposite of this strategy is the poop and scoop. This is where criminal speculators spread negative rumors around, encouraging traders to sell their stock so the criminal speculators can then buy it a lower price and later make a profit when the price rises.