Why Penny Stocks Are Perfect for Price Manipulation - dummies

Why Penny Stocks Are Perfect for Price Manipulation

By Peter Leeds

Penny stocks are a perfect vehicle for any number of traders, scam artists, or promoters to profit by artificially moving the price of shares. The majority of victims of these activities are ill-informed investors who don’t understand what is really going on with their penny stocks, and who may be a little too trusting.

Penny stocks become common targets for unethical behavior, because they are

  • Priced low: Some even trade for fractions of a penny. If a promoter can push the shares from one-tenth of a cent to two-tenths, they theoretically have doubled their money.

  • Thinly traded: The fewer shares that trade hands, the easier for a big wave of buying to move the price. When very few shares are being sold, any significant purchase may push the stock to much higher levels.

  • Appear legitimate: Because penny stocks have a listing on a stock market, many investors assume that they must be legitimate and high-quality companies. The truth is that shady characters often target companies close to bankruptcy, or those on the market only due to some legitimate operations in the past that have long ceased.

  • Plentiful: With thousands of penny stocks to choose from, dishonest players can move their efforts frequently and choose which type of company or story they want to push.

  • Anonymous: Most of these unethical players want to stay anonymous. They can potentially scam people out of millions through penny stocks, but never poke their heads out of the basement.

  • Vulnerable: Shady characters don’t need the permission of management or anyone else to run a promotion of any publicly traded company. Just like you, they can trade any shares on any market, and they very often run scams without the executives of the company having any knowledge of it whatsoever.

Some of the dishonest tricks that you may encounter include

  • Misleading information: Whether through a free e-mail newsletter, press releases, or a comment on a message board, these shady promoters know that they don’t need to trick everyone, just a few unwary investors is enough. They may stretch the truth, or flat out lie, to make a penny stocks company look extremely compelling.

  • Focusing on (ridiculous) potential: Instead of talking about how a company is almost bankrupt, or generates no revenues, the promoters focus on how its product — an engine that runs on gravity, a cure for that major disease — could change the world (even if it borders on the ridiculous). Inexperienced investors may fall for the promotion and think that the shares are a great investment.

  • Pump-and-dump schemes: A common practice with penny stocks, pump-and-dump schemes involve dishonest promoters who buy inexpensive shares in nearly nonoperational companies. The promoters talk up the shares and generate buying interest in the stock. That demand can drive the prices higher, until the characters behind the scheme sell all their shares and take their profits. Without the promotion, the stock collapses back toward the real value, usually near zero.

  • Coordinated price drives: This is different from pump-and-dump schemes because the investors in the stock are aware that the underlying company is awful. They hope to profit from increases in the share price of the near-bankrupt company and know that the only reason the stock would move is because of actions by buyers like themselves. They hope to ride the shares higher and jump ship before the promotion ends.

  • Scalping: Scalping is the process of an investment advisor or stock picker suggesting that investors purchase a certain stock while at the same time, they are selling those exact same shares. In other words, they are taking the exact opposite action that they suggest you take yourself. The practice of scalping is illegal, but financial professionals and stock pickers do it anyway.

The biggest problem with these tactics is that investors sometimes fall for them. Instead of asking why a free newsletter cares what they invest in or why it’s telling them about some stock, investors sometimes follow the dishonest information and purchase shares.

Generally, these individuals get burned and never come near penny stocks again.

The Securities and Exchange Commission (SEC), and other regulatory and enforcement bodies, take action against the worst scams from time to time. But because they they’re underfunded, these organizations have a hard time combating the dramatically rising wave of penny stock promotions.

While the pitfalls abound, you can easily avoid penny stock scams and promotions if you take these steps:

  • Choose companies on better markets. Only trade penny stocks found on the NYSE, AMEX, NASDAQ, and OTC-BB. Better markets attract more legitimate companies, while almost all scams occur with shares traded on the very low quality stock exchanges.

  • Avoid free picks. Whether offered free of charge from a free e-mail newsletter, an unsolicited fax, or an Internet message board, free picks almost always have hidden motivations behind them.

  • Do proper due diligence. Even if you get a pick from a trusted source, you should put it through your own rigorous due diligence. Make sure that you feel good about anything you invest in and always take responsibility for your own trading decisions.

  • Discern the source. You may hear about companies from a friend at work, or stranger45338 on some message board. Either way, even if they have good intentions, maybe they don’t have a clue about what makes a good investment. Don’t follow what they tell you just because they’re excited or adamant about the company’s prospects.

  • Build trust. When someone demonstrates a strong track record, or leads you to some winners, you should gradually (but cautiously) put more faith in them.