Boom or Bust: The Rundown on Penny Stocks

photo by Lara604 via Flickr modified by Curiousmatic 

Blue chip stocks like Apple and Google tend to get a lot of attention, but that doesn’t mean costly brand names are the only stock options in the game. Penny stocks are among the cheapest, riskiest, and sometimes surprisingly profitable options out there.

By Securities and Exchange Commission (SEC) definition, penny stocks are stocks with a share value below $5. From risks, to rewards, to million-dollar success stories and multi-million dollar scams penny stock prices are small, but the reward–and consequently the risks–can be a significant.

1. Penny stocks can be a bit of a gamble

Penny stocks, since they are not required to be filed with the SEC, are consequently significantly less regulated than more popularly traded stocks. This creates a considerable amount of risk for the owner due to the fact that reliable and concrete information is often hard to obtain.

2. A small share could mean big reward (or loss)

The puny price of penny stocks makes room for potentially huge gains, and likewise equally as big of a loss. To put it in perspective, if you buy 10,000 shares ($1,000 investment) of a $0.10 stock, and this stock appreciates by a mere $0.05, then you’ve already received 50 percent of your initial investment back. Alternatively, if the stock depreciates by the same rate–well, you know.

3. “Pump and dump” scams are a risk, but can also be leveraged

Penny stocks, possibly more so than popularly traded stocks, are permeated by scammers who employ a scheme called “pump and dump” to line their pockets. In the pump and dump scheme nefarious companies or investors artificially inflate the price of stocks by buying up huge shares of a company and then marketing and selling said inflated stocks to unsuspecting buyers.

Eventually, when the stock reaches a peak, investors sell the inflated stock for huge profits, leaving buyers holding the bag. Though this can be a huge pitfall in the volatile world of trading penny stocks, an acute trader can recognize such schemes and leverage them by making quick trades which capitalize on artificially inflated prices. Did we mention these schemes are highly illegal?

4. The possibility of major appreciation is unlikely but not impossible

A common misconception of penny stocks is that companies like Google or Microsoft were once penny stocks, and since have appreciated into the blue chip stocks that we know today.

Despite common perception, companies like Walmart and Microsoft entered into the market at $28 and $25 respectively. Misconception that stocks like this were once penny stocks is often derived from looking at the adjusted stock price, which factors in all stock splits and distorts the original market price per share.

That being said, it’s not entirely impossible to hit the metaphorical jackpot on penny stocks. Among some of the biggest former penny stocks are brand names like, Pier 1 Imports, Monster Energy, True Religion Apparel, and more.

5. Trust no one and be diligent

As we’ve mentioned previously, penny stocks are often difficult to obtain reliable information about. One of the most common mediums scammers use to reach unsuspecting victims are through penny stock emails.

In these emails promoters are paid by companies to push their stock regardless of its real value. The good news is that these email services are also required by the SEC to include a disclaimer at the end of such newsletters stating that such information is being delivered in best interest of the company.

If you’re intent on investing in penny stocks, penny stock expert Timothy Sykes recommends looking at stocks that have sustained growth and solid earnings over 52 weeks.

6. Buy slow but sell quick

For investors, the buying process of penny stocks should be a deliberate one–free of impulse–but the selling process, if one intends on making some money, is quite the opposite.

The prospects of penny stocks can be alluring–major returns being a huge drawing point–but according to Sykes, greed could be the downfall for traders who don’t know when to pull the trigger.

Sykes recommends that if a stock appreciates by 20 to 30 percent in value that it may be time to sell. Since any given penny stock may be artificially “pumped up” as we’ve mentioned previously, it’s wise to take any profit and move on.

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James Pero