We all want to become overnight millionaires. There are get rich quick infomercials on just about every late night television channel. Some people turn to the stock market in hopes of picking the next Apple or Google, but many times, this effort fails miserably.

Yet, the allure of a penny stock still draws in many investors. After all, where else other than Las Vegas can you put $5,000 down and walk away with double that in a short period of time? Here’s why you need to take extra precaution when investing in penny stocks.

penny stocks

What is a Penny Stock?

According to the SEC,

The term “penny stock” generally refers to a security issued by a very small company that trades at less than $5 per share…

Penny stocks may trade infrequently, which means that it may be difficult to sell penny stock shares once you own them. Moreover, because it may be difficult to find quotations for certain penny stocks, they may be difficult, or even impossible, to accurately price. For these, and other reasons, penny stocks are generally considered speculative investments.

The Risks Associated With Penny Stocks

The biggest risk when it comes to penny stocks is price manipulation. When you are talking about a stock that trades for $0.33 per share, simply having the price go up or down $0.02 makes a big impact. For example, if you invested $5,000 into this stock, you would own over 15,000 shares. If the price moved by $0.02 per share, you just made or lost $300. If the price moved by $0.20, you are looking at a gain or loss of $3,000!

Because of this, it is in the best interest of those invested in the stock to have the price increase. With penny stocks, making the price of the stock move is much easier than you would think. For example, you could easily go onto a stock trading message board and start talking about how great the company is and about a new product they are bringing to market. When others read these posts, they get excited and start to buy. This drives the price up, allows the first person to make some money, sell their holding and move on to another stock.

How does this work? While stocks are regulated, the companies behind penny stocks are so small and have such little (if any) revenue, they are not as high on everyone’s radar.

For example, most financial analysts are out researching other larger companies. They aren’t spending their time on the little fish. Therefore, you’ll have a hard time finding analyst research and recommendations on these stocks. This means that most of the information you hear is from people that might not have the best of intentions.

Even worse, in some cases, people will pay to get stories about certain penny stocks promoted. By doing this, they will pay a firm some money to publish reports that tout how great a company is and how they are poised to be a leader in the coming years. When you begin to do your research on the company, you see these reports that look legitimate to you, but they really are not.

How Do You Protect Yourself?

Other that not investing in penny stocks altogether, the only way to protect yourself is to do an incredible amount of research. For starters, you will want to make sure the information you are reading is honest or correct. The best way to make sure of this is to visit the company’s website or the SEC website. In both cases you will find reports that the company itself submitted talking about its business.

From there, you have to question everything you read. If you go on message boards, try to gain information from the poster. Do you see a pattern of them hyping the stock for a period of time? Maybe they hype for a few months, disappear, then come back hyping again. This could mean they buy low, hype the stock, sell high, and wait for the price to drop again.

Additionally, see what else the poster writes about. Maybe they are touting various penny stocks with the same message just reworded. Unfortunately, not only does this take time on your part, but the people good at hyping a stock will be sure to have various usernames and aliases making it nearly impossible to find a pattern. At the end of the day, you are left with trying to figure out why this person is telling you the information. Does it benefit them in any way? Most likely the answer is yes.

Final Thoughts

The allure of striking it rich overnight will always be there for many of us. If you decide to take the penny stock route, I urge you to be cautious. Read only reports released by the company, since the majority of other reports cannot be trusted. In addition, invest only with money you are comfortable losing. The odds are much greater that you will lose it all rather than double it.

Would you invest in penny stocks?

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