Penny stocks come with high risks and the potential for extraordinary returns, so investing in them requires care and caution. Penny stock companies are often headed for bankruptcy or are highly overleveraged, because of that investing in penny stocks is risky. There are two ways to make money with penny stocks, but they’re both high risk. Below is a breakdown on the risk and rewards of penny stocks. (Learn how to trade penny stocks by taking Investopedia's day trading course!)

The Lowdown on Penny Stocks

Penny stocks can be defined in many different ways. Most people logically assume that penny stocks refer to stocks trading for less than $1. However, the SEC defines penny stocks as stocks trading for less than $5. Generally, penny stocks trade on the Pink Sheets or FINRA’s OTC Bulletin Board (OTCBB). Both exchanges should be approached with extreme caution, but even more so the Pink Sheets since these companies aren’t required to file with the Securities and Exchange Commission(SEC). (For more, see: Use Caution Trading Pink Sheet Stocks.) And don’t get your hopes up with stocks trading on the OTCBB. It’s still difficult to find information to formulate a logical conclusion on whether or not the company is likely to survive, let alone thrive.

Whether the penny stock trades on Pink Sheets or the OTCBB, it will be challenging to find credible information. Keep in mind that there are no minimum standards for a company to remain on the Pink Sheets or the OTCBB. (For more, see: What Does it Mean When a Stock Trades on the Pink Sheets or the OTCBB?)

Penny stock scammers deceive by luring inexperienced investors into investing in cheap and worthless stock and taking their money. Be careful not to get caught up in one of these common penny stock scams. Below, are examples of other common penny stock scams you should avoid.

Pump-and-Dump Schemes

This fraud happens all the time. Promoters drum up interest in a scarcely known or unknown stock. Inexperienced investors buy up the shares, pumping the price. Once the stock has reached a certain inflated price, the bad guys sell, or dump, the stock at a huge profit. In turn, investors are left high and dry. These pump-and-dump schemes are often distributed through free penny stock newsletters, where the publisher is paid to list these unpromising and hyped-up stocks. If you get one of these newsletters, read the fine print on its website. You may notice that the companies or promoters are paying the author of the newsletter to feature them.

Short-and-Distort

This is the opposite of the pump-and-dump. Scammers use short-sell to make a profit. Shorting works when the investor borrows shares and immediately sells them in the open market at a high price, hoping the company stock falls so he can later scoop up sold shares at a lower price. He then returns these shares to the lender and nets a profit. Penny stock scammers short-sell a stock and make sure the stock falls by spreading false and damaging rumors about the company. Investors hold a losing stock, while short-sellers make money through their short-selling trick.

Reverse Merger

Sometimes a private company merges itself with a public company, so it can become publicly traded without the hassle and expense of going through more traditional methods. This makes it easy for the private company to falsify its earnings and inflate its stock prices. While some reverse mergers are legit, you can catch a reverse merger by reviewing the business’ history and detecting spotty activity in its merger.

Mining Scams

Gold, diamonds, and oil have always been alluring. One of the most famous mining scams was Bre-X, in the mid-1990s, when founder David Walsh falsely claimed his company found a massive gold mine in Burma. Speculation soared fast until the company’s valuation, all in penny stocks, was worth $4.4 billion by 1997. When the company collapsed, most investors lost everything.

The Guru Scam

Guru adds are commonplace, and sadly people fall for them easily. These false ads usually show you how the ‘expert’ became rich through a special ‘secret’ and acquired materialistic success, such as glitzy cars, lakefront houses, and boats. The ‘expert’ promises to share his penny stock trading secrets with you for a ‘one-time’ low sum. If someone dubs himself a guru or promises to make you rich, trash that email or envelope. There is no “one-size-fits-all" path to riches, and certainly not in the stock market. In a similar way, avoid those schemes that promise you unlimited success from a once-in-a-lifetime product or invention that claims to be the next Thomas Edison invention.

"No Net Sales" Scams

This is when scammers sell shares of a company, stipulating that investors cannot sell the shares for a certain amount of time. The investors buy because they are fooled into thinking there is huge and continuing demand for this stock. By the time the U.S. Securities and Exchange Commission (SEC) shutters these companies, investors are left with nothing.

Offshore Scams

The U.S. Securities and Exchange Commission says that companies who operate outside the United States do not need to register their shares when they are selling to offshore investors. Penny stock scammers love this. They buy unregistered and cheap company shares from an offshore location and sell the stock to investors in America at an inflated price. This influx of unregistered shares causes the company’s stock price to drop. Thieves make huge money, while U.S. investors are left with little, if anything, to pocket.

How To Avoid Scams

Certainly, the penny stock world is rife with market manipulation, fraud and chicanery, but investors should know that such abusive practices aren't the exclusive domain of penny stocks and micro-caps by any means, as the cases of scandal-ridden companies like Enron and WorldCom well prove. That said, how can you avoid being scammed by dishonest penny stock promoters who are out to make a fast buck? Here are some suggestions:

  • Know the difference between promotion and research. Promoters routinely hire newsletter writers to write flattering reports about their stocks. Many of these writers make a convincing case for investing in dud penny stocks, using hyperbole, outlandish projections and, in some cases, deliberate distortion, as these promotional pieces look very similar to sell-side research reports. The penny stock investor has to learn to distinguish between stock promotion and legitimate equity research. One way is to read the "disclosures" section at the end of the report, and see whether the writer is being directly compensated (often in a combination of cash and stock) for the report by the company they're recommending. If that's indeed the case, this is essentially an advertisement, not an actual research report.
  • How credible is the company's management? A company's success depends on the quality of its management, and penny stock companies are no different. Although you're unlikely to find a Steve Jobs running a penny stock company, you should still delve into management's track record to determine whether company executives and directors have had any notable successes or failures, regulatory or legal issues and so forth.
  • How do the financials look? Although penny stocks generally don't furnish in-depth financial information, it won't hurt to check the financial statements the company does release. Scrutinize the balance sheet to learn if the company has any substantial debt or liabilities outstanding, as well as its amount of net cash on hand. If the income statement shows huge growth in revenues of late, that's one promising sign
  • What's the quality of disclosure? The more disclosure the company provides, the better, as that indicates a greater level of corporate transparency. For instance, the OTC Markets Group divides its securities into a three-tier marketplace: OTCQX (the top tier), OTCQB (middle tier) and OTC Pink, based on the integrity of a company's operations, its level of disclosure and its investor engagement. Since OTC Pink company reporting can be spotty, OTC Markets Group further segments that group, based on the quality and quantity of information provided, into Current Information, Limited Information, and No Information. Obviously, investing in a company with limited or no information is best avoided, as the phrase "no news is good news" doesn't apply in the penny stock world. In addition, stocks for which OTC Markets Group advises investors to exercise additional care and thorough due diligence typically flash a skull-and-crossbones "Caveat Emptor" sign. Penny stocks may earn this symbol for a number of reasons: the company or its insiders may be under investigation for fraudulent or criminal activity, or the company may be involved in such dubious promotional activities as spam emails.
  • Is the business plan achievable? Investors should evaluate whether the company's business plan is achievable and if it actually has the asset base it professes to have. Recall the infamous case of Bre-X, the Canadian junior miner that in the 1990s claimed to have found one of the world's biggest gold mines in Busang, Indonesia: a story that turned out to be a colossal fraud (For more, read: The Biggest Stock Scams Of All Time). Before it was found out, Bre-X shares climbed from 12 cents to C$280. Its collapse in 1997 wiped out C$3 billion in market value, and likely a fair share of penny stock investors.

How To Buy Penny Stocks

Once you've learned to dodge scammers, here are five steps to follow when purchasing a penny stock. It's important to evaluate whether the stock has upside potential: You're investing because you'd like to get a return, right? So you need to ask yourself whether the penny stock you're considering truly has upside potential, or if it seems more to be a flavor-of-the-day kind of stock, such as a company's that's trying to ride the coattails of the latest investment fad. You should devise a realistic risk-reward assessment for the stock, even if you're only investing a few hundred dollars in it.

  1. Limit your holdings and diversify: You might be excited about the prospects for your favorite penny stock, but you still need to protect yourself. Cap your losses by limiting your holdings in the stock to no more than 1% or 2% of your overall portfolio. It also makes sense to diversify your penny stock portfolio, which shouldn't exceed 5% to 10% of your overall portfolio, depending on your risk appetite.
  2. Check liquidity and trading volumes: Even if you've made a successful investment in a penny stock, you're going to need to be able to sell your shares. You should have adequate liquidity and trading volumes in the stock so that you can trade it efficiently. Otherwise, you may wind up in a situation where there are few buyers and wide bid-ask spreads, making it nearly impossible to convert your paper profit into an actual one.
  3. Know when to sell: It's very rare for a penny stock to be a long-term buy-and-hold investment. The sector is built on short-term trades, so it's as important to know when to sell as it is when to buy. If you notch sizeable gains over a short period in a penny stock, consider booking them now rather than waiting for bigger profits that may never materialize.
  4. Search for high-quality stocks: Basically, some penny stock companies are worth more than others. Good prospects include ventures that are set up by experienced managers who have successfully exited a previous company; stocks with binomial outcomes (such as biotechnology stocks or promising resource companies) and fallen angels. If getting a low stock price is driving your investment decision, then fallen angels – which appear in abundance towards the end of a bearish trend, whether in a specific sector or the overall market – are among your best bets (although strictly speaking, they're not really penny stocks). Many leading technology stocks today were trading in the low single-digits at the end of the 2000-02 "tech wreck," while household names like Citigroup Inc. (C) and La-Z-Boy Inc. (LZB)  traded below a buck in March 2009.

The Bottom Line

Penny stocks are a huge gamble—you could have better odds of seeing a profit by visiting a casino than you would by dabbling in penny stocks. Despite the short-term potential for gains, stick to a sustainably profitable approach by buying shares in proven companies with strong track records. If you want to allocate some capital to speculative plays, then it may be best to look at companies trading between $3 and $5, but only pull the trigger after substantial research that leads to conviction in your position. (For related reading, see: What is the Difference Between a Penny Stock and a Small-Cap Stock?)

Note: this story was complied with reports from Leah Zitter and Elvis Picardo.

 

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