What’s a Penny Stock Really Worth?

In this unstable ecomony, harried investors are re-evaluating their strategies. Low-priced “penny stocks” can be an attractive investment, but did you know they one of the riskiest choices?

What is a Penny Stock?
In the U.S. financial markets, a penny stock is any stock that trades outside if one of the major exchanges (NYSE, NASDAQ, or AMEX). According to the SEC definition, they are low-priced, speculative securities of a very small company. Penny stocks also go by the names microcap stock, small caps, and nano caps.

With very low initial buy-ins, penny stocks can return cracy good profit when the market turns around. To add to the attraction, many believe that smaller companies have the best possibility for growth during an economic rebound. However, with the promise of higher yields comes high risk.

Risking Your Pennies
New investors can be lured into buying penny stocks for both their easy access price point and the promise of quick riches, but it’s important to understand that the losses can be just as swift. The SEC warns that penny stocks are high risk investments.

Risks include:

• Volatility: Sudden changes in demand or supply of the stock cause volatility.
• Lack of liquidity: The lack of a ready market can make it extremely difficult to sell the stock.
• Fraud: Both volatility and lack of liquidity make penny stocks highly vulnerable to manipulation.

Stocks that trade outside the major markets are traded on “Pink Sheets” and are subject to little to no regulation compared to major markets.

Pump and Dump Schemes
Penny stocks are often fraudulently promoted to produce a quick surge of trading, followed by a rapid fall. According to the SEC, methods include:

• A company’s issues a glowing press release about its financial health, or a new product or innovation.
• Supposedly unbiased financial newsletters tout the company as the latest “hot” stock.
• Chat rooms and bulletin board postings may urge you to buy the stock quickly or to sell before the price goes down.
• The company may be mentioned by a radio or TV analyst.

When this happens, investors purchase the stock in droves, creating high demand and pumping up the price. The scammers then sell their shares at the peak price and discontinue promotion. The price plummets, and all the other investors lose.

While not all penny stocks are fraudulent, it’s important for investors to understand how the scams work in order to avoid them.

Image Credit: walknboston, Flickr