Penny Stock Promoters: What You Need to Know

Penny Stock Promoters: Choosing which stocks to buy is often a balance between risk and reward. Riskier stocks tend to have the potential to generate the highest returns as well as the greatest chance of losing value.

Most well-balanced portfolios hedge against these bigger gambles with low-risk stocks. The thing is that many investors only have so much money to invest. In a search for the best value, many of these people turn to so-called “penny stocks.”

What are Penny Stocks?

Penny stocks cost significantly lower than other stocks. The SEC defines a penny stock as one that costs less than $5 per share but defining a penny stock is more complicated than that. After all, there are companies on major exchanges that trade for less than $5 per share.

That doesn’t make these stocks “penny stocks.” For example, after the stock market crash in 2008, shares in Ford Motor Company (yes, the one that makes Mustangs) were priced at less than $2 per share. That doesn’t make Ford a penny stock.

The concept of a penny stock is much more complex than the price. The term implies a certain level of risk, so much so that “penny stocks” are not listed on major exchanges.

Why are Penny Stocks Not Traded on Major Exchanges?

Major exchanges, like the NYSE, have strict listing requirements. Included companies need to make the grade, so to speak. Because of this, the stocks listed there are not as risky as stocks that are not traded on the major exchanges, like penny stocks.

Where are Penny Stocks Traded?

Penny stocks tend to be relegated to the Over-the-Counter Bulletin Board (you may know it as OTCBB) or the Pink Sheets (aka the OTC Markets Group).

The OTCBB is more strict in its listing requirements than Pink Sheets, but both of these listing services include stocks that are significantly riskier than those on major exchanges.

So, What is a Penny Stock Then?

In order for a stock to be considered a true penny stock, it will be listed on the OTCBB or one of the listing services in the OTC Markets Group and be priced less than $5 per share. Most of these companies are trading at such a low price because they want to avoid the financial disclosures that the major exchanges require.

That’s not to say that you can’t make money from them. Some people do. They find stocks that are trading for $1 and their prices soar to $10 in a matter of a few weeks. However, many more penny stock investors are not so lucky.

Disadvantages of Penny Stocks

Penny stocks have lots of disadvantages. Many of the companies listed are ones that you have never heard of and they don’t publish the same information as bigger, more reputable companies.

That doesn’t mean they are all bad, but you can’t make an informed decision when there is no (or little) information available. In many ways, this makes buying a penny stock is like buying a car you’ve never heard of without test driving it first.

The other problem with penny stocks is that they are easy to manipulate. Investors are attracted to the low price but the stocks themselves tend to be thinly traded or followed in general and this makes them vulnerable to manipulation by so-called “penny stock promoters.”

How Penny Stock Promoters Work

Penny stock promoters will buy a bundle of the things then advertise the stock, promising big returns.

These people may exaggerate or make outright false claims. They spread rumors of an acquisition or a lucrative deal with a blue-chip company – anything to convince people to buy that penny stock.

As more people take the bait and buy shares in the penny stock, the price per share goes up. The stock promoter then sells his or her shares at a profit. In turn, the shares in the penny stock company drop.

The Dangers of Penny Stock Promoters

Stocks tend to gain or decrease in value in accordance with how often they are bought or sold. It is the basic law of supply and demand.

There are a finite number of shares so the more people that want them, the more valuable they are. Conversely, when people sell stock, the shares can take a hit. For big stocks, the effect can be marginal if it exists at all.

Most retail investors don’t deal in enough volume to have an impact when millions of shares are being bought and sold every day.

Penny stocks are not traded very often. When someone, like a penny stock promoter, buys a ton of the things, the price of the stock could increase on that transaction alone.

This fact makes it easy to manipulate penny stocks. Buying enough shares to cause your own price fluctuation is one thing – and it is a different, gray matter altogether – but penny stock promoters do this to their advantage and your detriment.

How You Can Avoid Falling Victim to Penny Stock Promoters

Penny stock promoters are going to play on your desire to be a successful investor. They will make promises and claims that simply aren’t true to try and get you to buy shares in a company. Seeing through their manipulations can be difficult, but the general rules of investing always apply:

Due Diligence

Always, always, always do your research.

People have their own view of company events, economic trends, and fundamentals. You could interpret events very different from someone else. Even analysts do not always agree. Do your own research and decide for yourself whether it is a good investment.

Remember the Source

You will find many free websites and bloggers who talk about different stocks and investment strategies, and many of these are solid pieces of writing that give you a starting point for your own research. These sources are required to disclose any positions they have in the stocks mentioned.

As an investor, you should pay attention to that. Likewise, don’t take what a company says about its own future at face value. Remember the source.

Don’t Trust Free Advice

Furthermore, free advice may not be in your best interest. Some of those free sources are going to be penny stock promoters trying to trigger a price fluctuation in a stock.

Exercise Orders

Another strategy to use when buying penny stocks is to use orders. In general, you should choose a limit order instead of a market order so that you pay the price you intend to pay for your shares.

Penny stocks are so thinly traded that a large purchase can push the needle and you could end up paying more than you intend. You may also want to put in a stop-loss order so that you limit your downside.

Practice Makes Perfect

Before you attempt to invest in pink sheet stocks, consider opening a practice or phantom account. These accounts let you invest in penny stocks without using actual money. Granted, you don’t earn any actual returns either – think of it like fantasy football – but a pretend investing portfolio is a good way to see if your reasoning and overall investment strategy is a good one.

Alternatives to Penny Stocks

Your best alternative to a penny stock is to look for a company that is listed on a major exchange and undervalued. Remember how Ford was trading at less than $2 in 2008?

In January 2011, the stock topped $18 per share. Finding those market inefficiencies is rare, but it can be done. Ideally, you want to look for six things:

•        Companies with higher prices
•        Solid cash flows
•        Dividends
•        Strong fundamentals
•        Reputable
•        Listed on major exchanges

You may not be able to tick all the boxes, but it is a good blueprint of what to look for in a low-priced penny stock alternative.

How to Evaluate Stocks

In order to find stocks that meet these criteria, you are going to need to do some research. This could involve scouring the stock market several times a day and reading the company news and SEC filings for every potential investment, or you could buy your research.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.