Insider’s Guide To Penny Stocks

So you still want to play?  Despite all of the warnings, the appetite for penny stocks is greater than ever. Investors routinely see triple digit gains and think that even if they can capture even a portion of those returns they are ahead of the game.

Sadly this rarely happens, as they become victims of a “pump and dump” scam.

Here’s how it works.

Stock promoters will approach microcap companies and offer to get people to buy their stock in exchange for either company stock or a fee.  They then go on to tout that companies stock via their website or newsletter (pump). When the feeding frenzy commences and the buyers come in, the promoters and insiders sell their stock (dump). All of a sudden the buying stops, and the new purchaser has no one left to sell to and is left holding the bag. They are then forced to sell into a highly illiquid market and often times take significant losses on their positions. More often than not they end up selling their stock (at a big loss) back to the original seller who is now looking to re-buy the shares (at a considerably lower price) to perpetrate the scam again in the future!!!  Rinse and repeat.   And then there is the “wrong message” scam, where promoters will leave a message on a person’s voicemail giving them a hot tip that was supposedly intended for someone else.   This appeals to the greed of a potential investor as they are lead to believe that they are getting some sort of inside information.

So why do people fall for this time and time again? One of the main reasons people get sucked into these scams because from time to time they are allowed to “win” initially. This is where it can get dangerous, as they begin to trust the promoter they are following. In this version of a ponzi scheme the investor is encouraged to increase the size of their investment and inevitably this ends badly.    So are all penny stocks bad? Should one NEVER invest in penny stocks? Not necessarily.  Check out our previous article about the time and place for such investments.

If you do decide to invest in penny stocks, here’s how to protect yourself:

1. Never, ever take a tip from a website or newsletter that specifically recommends a stock. If this were such a great investment, why would they share it with you? Usually for free, no less!
2. Do not give your contact info to sites that tout penny stocks.  These sites use this info to increase their subscriber base which then makes them more attractive to microcap companies who want them to tout their stock. In effect, you are helping the scammers! Also, be wary of sites which claim to tell you which stocks are being touted. Why? Because guess who is behind that site? That’s right-the scammers!
3. Always read the fine print. Buried somewhere it will explain to you how they are compensated. As long as they report this information, technically they are not breaking the law.   Some sites will routinely not do this, and hope to elude prosecution. Unfortunately,   you can’t expect the SEC to investigate all of these small potatoes websites when they couldn’t even catch Madoff!!!
4. Be wary of tips given to you by friends. More often than not, they may be unknowing participants in these scams and are merely trying to be helpful. I’ve seen more than one friendship go belly-up after stock recommendations gone badly.
5. Never, ever take a recommendation from a cold-calling broker. If you’re not going to take tips from friends and people you trust, why should you take a tip from someone you don’t know?

Here’s what you should do:

1. Do your own homework. Does the company have a website or a phone number? Go ahead and make a phone call or send an email.
2. Ask yourself these questions. Does the company have tangible assets? Do they have a product that you use? Have they been mentioned in the mainstream media (not tout sites!)? Then conduct your normal due diligence that you would do for any other investment.
3. Use the EDGAR database. This will show whether or not the company has filed financials with the appropriate regulatory authority. Remember, not all microcap companies are required to file, but those that do are typically more transparent.
4. Use caution. Only invest an amount of money that you would be comfortable if you lost the entire investment.   Never allow someone to tell you how much to invest. You decide.
5. Get lucky. While you may not be able to uncover the next Microsoft (MSFT) or Google (GOOG), you just might find the next (fill in the blank).

Knowing what you are getting yourself into can be the difference between losing a bundle through your own stupidity or through no fault of your own. By learning about how this market operates, you are stacking the odds in your favor and giving yourself a greater chance to be successful.

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