Know Why Penny Stocks Are Risky - dummies

Know Why Penny Stocks Are Risky

By Peter Leeds

You know that penny stock investing is risky. You’ve probably heard some pretty scary stories about scam artists and investment dollars disappearing overnight. Although investing well in fundamentally solid penny stocks can be very lucrative, the unfortunate fact is that many of the negative things that you’ve heard about penny stocks are all too real.

Whether you’ve heard about an elderly widow being swindled out of her life’s savings by some con artist over the phone, or some 14-year-old child running a pump-and-dump scheme out of his mother’s basement, such awful stories have some basis in reality. By recognizing this fact, you will be able to sidestep potential pitfalls much more easily.

Penny stocks represent low-quality companies

Stocks rise in value when a company does well and fall in value when a company does poorly. Therefore, more successful companies typically have higher share prices, while the majority of troubled companies become penny stocks, if they aren’t trading at those levels already.

When a penny stock company does really well, its shares tend to move higher and eventually may rise above five dollars per share. And as soon as the price rises above five dollars, the stock is no longer considered a penny stock.

As a consequence, the universe of penny stocks is made up of only the companies that have not yet done well enough to rise above penny stock territory. The result is that penny stocks are lower-quality companies, and lower-quality companies tend to be penny stocks.

Penny stocks are subject to price-manipulation scams

Because penny stocks are more thinly traded, and prices are much lower per share, they tend to be easy targets for price manipulation. They also tend to represent lower-quality companies and trade on markets with fewer manipulation controls and governmental oversight.

Pump-and-dump artists may drive up the shares of near bankrupt companies through their free online newsletter, only to take their profits and walk away to let the stock crash back down. Dishonest promoters may paint a very weak company in a positive light, a process called putting lipstick on a pig.

In any case, the prices of shares may rise well above what they are realistically worth. This price manipulation puts investors (who haven’t done proper due diligence) at significant risk, because shares always return to their appropriate valuations. The good news is that you can avoid these types of price manipulation pitfalls pretty easily.

Trading penny stocks is a game of chance

For some investors, penny stock investing can be like a playing a one-armed bandit at the casino or buying a lottery ticket. Such investors have resigned themselves to the fact that they are taking a chance on a big gain, but will probably lose. The house odds are stacked against them.

But traders who perform proper due diligence never consider penny stock investing like gambling. They only invest their money when the “odds” are stacked in their favor. They have a clear understanding of which penny stocks to avoid, and which are likely to increase in price, and why, and when.

Whether or not penny stock trading is like playing at the casino depends on how you approach your trades.