Penny stocks have a controversial reputation in the stock market. Most professional investors stay away from them, preferring to hold on to stock. This is Warren Buffet wisdom, where the investing luminary advises newbies to buy stock with the intention of holding and not trading right away.
However, casual investors and newcomers may not have the cash to purchase high-end stock with the intention of holding on for years. Low-end and cheap penny stocks are highly attractive to those who want to play the market and earn a quick buck.
The practice of day trading using penny stocks is rather common. But it is not necessarily safe. Market volatility is not the only thing penny stock traders have to worry about. There’s a more nefarious threat: scammers.
Because traders buy and sell penny stocks at such a rapid rate, this sector is extremely attractive to fraudsters. One of the most common types of fraud penny stock traders are warned against is the pump-and-dump scam. You need to discern which penny stocks to buy.
What is a Pump-and-Dump Scheme?
To better understand this type of scam, consider this old joke: an oilman dies and goes to heaven. At the Pearly Gates, St. Peter tells him that he can’t enter because heaven has too many oilmen. The oilman asks if he can enter if he persuades another oilman to go to hell instead. “Okay”, says St. Peter.
After a while, St. Peter sees a line of oilmen heading towards hell. Astonished, he asks the oilman how he convinced all of them to go to hell. The oilman simply says, “I told them they’ve found oil in hell.” Then the oilman himself joins the line descending to hell. More perplexed than ever, St. Peter asks why he’s going to hell as well. The oilman replies, “you never know if there’s actually oil in hell.”
This is a hilarious analogy of a pump-and-dump scam. Basically, a conniving scammer manages to hype up practically worthless stock to get thousands of unsuspecting investors to buy them. When these stocks are bought in a hurry, the price is artificially inflated. Eventually, the prices crash down to normal. But when that happens, these buyers would stand to lose a lot of money.
Spotting a Pump-and-Dump Scam
Identifying a pump-and-dump scam is fairly easy. They usually start with rumors, just like those spread by the oilman in heaven. You may already be familiar with emails proclaiming incredible returns and even more spectacular assets. In a similar vein, a conman even managed to sell worthless stocks of a company claiming it had found a “cancer cure.”
If you see far-fetched claims such as this in emails or hear them through word-of-mouth, be very cautious. If it sounds too good to be true, it probably is. It’s important to do your own research to verify any claims about cheap stocks.
More importantly, control your urge to do what everyone else is doing. The oilman in the analogy falls victim to his own lie. Likewise, don’t follow the herd “just in case” because you will fall right into a pump-and-dump trap.
How to Identify the Good Penny Stocks from the Scams
Though the penny stock sector is rife with scams, this doesn’t mean all penny stocks are worthless. Some of the most famous brands in the world started off as penny stocks or fell into the penny stock range. Sirius XM and Monster Beverage once traded under a dollar in the market. There are also other major entities that have fallen on hard times, such as Fannie Mae and Freddie Mac, which have both traded under $5 since the recession.
So how can a regular investor tell a good penny stock that can be worth millions one day from a scam? That would require some research. Financial advisors recommend inspecting the assets or commodities the companies sell. “What is the product?” is the question investors should ask.
For example, certain tech companies in the “pioneering” stage may trade for pennies until the product is consumer-ready. Another example is mining companies, which may not be worth much in the exploration stage. Fortescue Metals Group is an Australian mining firm that was trading for around three cents in 2003 but has since become the fourth largest iron producer in the world.
What it comes down to is this: understand the company before buying the stock, even if it’s just penny stock. Don’t be too keen to believe what others say. And certainly, don’t buy into anything stated in chain emails. If you can stick to these rules, you can avoid scams and actually make money with penny stocks.