The Pitfalls of Trading Penny Stocks

by Dual Income No Kids on November 17, 2009 · 0 comments

For those of us who are prudent, its enough to see solid, modest returns on our investments. We spend a great deal of time playing with stocks screeners and researching investing techniques advocated by sensible gurus like Peter Lynch. However, instead of putting in the homework to come up with a profitable investing strategy, some people don’t want to exert the effort. They want the fast easy money right away.

Therein lies the appeal of penny stocks. For those who are unfamiliar, a penny stock is a security with a price per share of less than $5 that is not traded on one of the major stock exchanges. Penny stocks are appealing due to their extremely low price (allowing an investor to scoop up a large number of shares) and a perceived high growth potential. Often, penny stock traders aren’t investing for the long term, instead, they will buy a large number of shares in a security, wait for some upward movement, and then sell. A movement of a few cents can yield a tidy profit if you own enough shares.

Although that may appear appealing, there are two problems associated with trading penny stocks: susceptibility to fraud/scams and unavailability of good financial information.

First, penny stocks scams are common in equity markets. We’re all aware of various stock frauds, and it seems like every couple of months we hear about more corporate fraud cases. They’re common enough with regular stocks, but even more prevalent in the penny stock system.

A good book on this subject is Jordan Belfort’s The Wolf of Wall Street, detailing his rise and fall as a stock manipulator. If you read his book – or have seen the movie Boiler Room, they deal with the same issue – then you’re probably familiar with the popular “pump and dump” scheme, where a stock manipulator will buy a large number of shares in a company, then through a variety of means such as cold calls to potential investors, paying off supposedly independent stock evaluators in the media, etc… will “pump” up the value of the stock. Shortly thereafter, the manipulator will sell of their shares in the security, and with the sudden lack of momentum the stock value will fall and all the new investors will lose their money.

Penny stocks are an ideal mechanism for performing this type of manipulation due to their inherent volatility, lack of media attention and their inherent attractiveness to unwitting investors looking to make a lot of money quickly. By the way, that is just one example of potential fraud when dealing with penny stocks!

Second, in addition to their susceptibility to manipulation, penny stocks are difficult to invest in because there isn’t a lot of information about them. On the other hand with a larger company like Google or McDonald’s there is a lot of financial data for you to analyze. Since penny stocks aren’t listed on a major stock exchange they aren’t subject to the same financial disclosure obligations other securities are.

Personally, I’ve had a variety of people try to talk me into dabbling in penny stocks, but you’ll never convince me. If I’m going to gamble then I’ll find a sportsbook or a poker game. There’s no way to effectively evaluate a penny stock, and there’s so much fraud and manipulation out there you can’t ever be 100% sure that what you’re participating in is legit.

Readers, any of you have experience with penny stocks?

– Michael

p.s. For more info on stocks click here.

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