The Truth About Penny Stocks

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Let’s get one thing out of the way before viewing the video – Penny-stocks are some of the highest risk “investments” available in the market. The odds are heavily slanted towards further losses and even bankruptcy. There are a few outliers, however, that return hundreds of percent in gains and this is what keeps investors coming back to roll the dice again.

Video Analysis: Penny Stocks

A penny stock can be defined as a company with a very low share price (less than $5), that is not listed on a major stock exchange and has very low liquidity or trading volume.

Penny stocks can also be very volatile with a wide bid-ask spread and some may even require you to call your broker to actually execute a trade. These characteristics add to the problems of buying stock in distressed firms.

A more broad definition may identify a penny stock as any low priced stock in a distressed firm. These are naturally very high risk but they could be a big winner if everything works out right.

Penny stocks are problematic and very high risk for three main reasons:

1. Penny stocks are prone to manipulation and scams
It is possible for a firm or individual to acquire a large position in a penny stock for one price and then promote the stock through newsletters, advisory services, direct mail, telemarketing or to brokerage account holders and then sell the stock at a higher price just as these new buyers are making their purchases.

This is sometimes referred to as a “pump and dump” scam (illegal) or a “chop stock” scam (technically legal). In either case, the buyer has usually taken the bait of overly optimistic projections and will wind up with losses while the scammer has walked away with a nice profit. There are some estimates that up to 50% of daily trading volume in penny-stocks is related to one of these two scams.

2. Penny stocks are volatile
A stock in this category is usually a distressed firm. That means they may be going bankrupt or may already be in a reorganization. They are priced this low because they are extremely high risk. The odds are stacked against any investor making money in a company like this. That means that large and sudden price moves are common. More often these moves are down, not up.

3. Penny Stocks have liquidity issues
A firm like this may not be listed on a major stock exchange. The quotes you see for the stock may be coming from an over the counter service like the OTCBB. That may mean that buying or selling the stock will require you to call your broker and have them look for other buyers or sellers. This is expensive and adds to the risk of the trade.

Additionally, a stock listed on an over the counter quote service does not have the same reporting requirements of other larger firms. This means that you may not know what the company is really doing or how they are actually performing. Quite often there is a lot of overly optimistic hype around a stock like this but investors have no way to know whether this information is correct or fabricated.

However, is there something inherently evil in wanting to buy stock in a seriously distressed firm if you understand the risks? No. In fact, there are many things you can do to make sure the risk is something you are willing to take on. Not all penny-stocks are unlisted. Some with a price of more than $1 will be listed on a regular exchange and may have a lot of trading volume and reduced liquidity issues for small positions.

Sometimes, firms like this do perform really well and a few outliers could create some very large profits for a small trader. The bottom line is to understand what risks you are taking when buying a company like this. Ignore the hype and keep any positions small. Set your expectations low because the odds are stacked against you and enjoy the ride wherever it takes you. Often companies like this can be fun to watch and you may actually learn a lot just paper trading them.


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