Investors, especially those new to the stock exchange, are always looking for easier ways to turn their money into large scale profits. Penny stocks have been around for a while, and their name makes them sound dated. And most people like to steer clear of these stocks because of their assumed illegality.
Penny stocks are not illegal. The U.S. Securities Exchange and Commission recognize them as any stocks worth under $5. However, the markets in which they are sold are not under any official authorities’ regulations, ultimately making them prey to scams and frauds.
In this article, you will find out what penny stocks are, what makes them such high-risk investments, and which malpractices to look out for. And finally, if you are still determined to invest in penny stocks after these warnings, you will find some tips to help you along the way.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
What Are Penny Stocks?
The name penny stock was coined due to the meager prices of these shares. Although they are officially recognized as under $5, they rarely reach this price, staying below $4 or $3. SEC defines these stocks to be priced below $5 while in the U.K, they are often priced below £1.
It is a given that penny stocks are issued by companies with low market capitalizations, but this does not make them illegal. They are required to fulfill a few legal requirements. The issuer should have an operating history of a minimum of one year, a market value of securities of at least $50 million, or a net income of $750,000. Regardless of these legalities, penny stocks are still manipulated.
Problems With Penny Stocks
Yes, penny stocks are legal. However, several factors give penny stocks the bad reputation they have today. A stock is reliable when regulated, meaning that to be a part of an official listing, it must adhere to its standards.
Stocks found on large exchange markets such as the New York Stock Exchange (NYSE) or the NASDAQ stock market belong to reputable public companies required to submit financial records regularly to the SEC for investigation and regulation. Penny stocks are seldom found on these stock markets. Hence they are not subject to any of these terms.
A Risky Environment
Penny stocks are bought and priced on over-the-counter exchanges such as the OTC Bulletin Board, OTC Links (Pink Sheets), or privately owned OTC groups. Penny stocks can also include private companies with inactive trading operations, companies that are close to bankruptcy or making very low profits. Their quotations are done electronically.
Most companies fall back on trading through OTC exchanges when they cannot meet the SEC’s strict requirements, meaning their financial performance is rarely subject to any regulations or verifications. While the OTCBB does maintain some level of listing requirements, Pink Sheets do not. To sum up, the ‘market’ where you will find most penny stocks is a risky place itself.
Price Fluctuations
Secondly, penny stocks are highly volatile for several reasons. They do not have frequent buyers, making even a few transactions involving them have an exaggerated effect on their market. This means penny stocks do not need a lot of cash to push them up or down. If a single investor buys a lot of penny stocks, that one transaction itself would shoot up its price.
They are also very cheap, which means rookie investors get attracted to their prices and decide to stock up on them without doing their background check. Penny stocks have very low liquidity. The company itself is in a distressed situation; paired with an overall lack of investors and a proper market for their transactions, it will be challenging to find genuine investors looking to purchase them.
Stocks are generally considered short-term, liquid investments, and these are not, making penny stocks all the more unattractive. Due to these reasons, penny stocks have become a home to many scammers.
With chunks of information missing and no authorities present to correct them, scammers find it easy to fill these holes with false information and rumors that benefit them. Prices are rarely accurate because of fraudulent schemes that manipulate them, and because quotations are electronically listed, there is no way around them.
Are Penny Stocks Gambling?
Penny stocks aren’t gambling if you invest with strategy. But just like with any other stock, you can gamble on valuations. If you gamble in an organized fashion without a license, you may run into legal trouble, but to bet on an investment paying off isn’t illegal.
Schemes to Watch Out For When Trading Penny Stocks
While you may be tempted to invest in penny stocks because you have a particular strategy in mind, you may want to make sure it does not fall in one of these categories.
Pump and Dump
A common practice, pump, and dump occur when scammers push up the prices of penny stocks they currently hold (pump) through advertisements and falsified claims that promise high returns on them. They may even do this by hiring people to buy a few of these stocks to show a rise in their prices, which would attract investors.
Once interest is created, the bad guys will sell (dump) these stocks in large amounts resulting in a profit for them, a fall in the prices of penny stocks, and ultimately a bunch of investors holding stocks that are now worthless.
False Advertising
Exaggerated advertising is another warning sign. People will often use large and exciting words such as ‘promising returns’ or ‘make millions’ or ‘invest now or regret later’ to drive up the hype. False emails and newsletters like these are not difficult to find, so if you ever come across one, make sure you trash it right away.
Merger Deceptions
This is another creative way for scammers to trick investors. Private companies may sometimes merge themselves with public companies that are already listed on the stock exchange. This kills two birds with one stone.
Neither are they subject to any strict restrictions, letting them enter these markets easily and second, they may also try to use the public company’s profits to manipulate their one. In this case, it is wise to look into the company’s financial statements before investing.
Some Helpful Tips for Trading Penny Stocks
If you still want to give penny stocks a try even after all these warnings, we won’t stop you from doing so. Be quick and stay alert in this market. Below are a few tips that might help you when handling these high-risk investments.
- Do your research. We cannot emphasize this enough. It is vital you go through financial statements, read articles, or find news from verified sources and ask around from trustworthy and experienced brokers about a penny stock before investing in it.
- Clear out the noise. Filtering through all the jargon is essential. People are always talking and exchanging information in the stock market. It is your job to ignore exaggerated claims and find facts that actually make sense.
- Do not rush. Penny stocks are highly volatile, meaning their prices may rise too high or drop too low in a day. Sit back and track the performance of your stock for a week before making your move.
- Do not aim too low. Try to avoid buying penny stocks worth 50 cents or less.
- Sell quickly. If you do end up buying penny stocks, do not hesitate to sell them as soon as the price inflates. Rates fall quickly more often than they rise, so do not aim for very high profits and get rid of your stocks when you have the chance.
Author’s Recommendations: Top Trading and Investment Resources To Consider
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Conclusion
Penny stocks may seem exciting, we get it, and there is a reason why they still exist today even though they are surrounded by a world of problems. But not all penny stocks are bad. Some of them are actually worth the investment. It only takes some time and hard work to find them.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
Affiliate Disclosure: We participate in several affiliate programs and may be compensated if you make a purchase using our referral link, at no additional cost to you. You can, however, trust the integrity of our recommendation. Affiliate programs exist even for products that we are not recommending. We only choose to recommend you the products that we actually believe in.
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