Penny Stocks

Buying Penny Stocks: The Dos and Don’ts

The other day I was looking up some stock market anecdotes and came across the story of the infamous ‘pump-and-dump’ operation in the penny stock Lithium Exploration Group, Inc. (LEXG). Here’s how the chart looks, and following below is a narrative of what happened.

LEXG was an obscure mining company and the stock was languishing around the $0.10 levels for a long time – you can see the flat graph from 2009 till around March 2011. This is when the stock started getting heavily promoted across the Internet and through emails around the world. This ignited investor interest (“what’s there to lose at $0.10 anyway?” most thought, and jumped in). A classic ‘pump’ operation, the stock became the subject of discussions across chat rooms, forums and the media, and the price took off for the moon. From $0.10 on March 15, the price catapulted by 10,000 percent to $10.57 on April 28! From thereon, the insiders sold into the frenzy, the ‘dump’ taking the stock back to $2.50 levels by May. A select few made a pile of money, and lots of investors lost their shirts – all victims of the ‘pump and dump’ scams so frequent in penny stocks realm.

LEXG-Pump-and-Dump

There were other penny stock rip-offs like this, I discovered – you could look up H&H Imports where famous rapper 50 cent is alleged to have tweeted up its price 270 percent in a few hours, or the My Vintage Baby fiasco in which the price was manipulated up from 40 cents to $2.88 and pumpers later dumped the stock making $9 million along the way.

Time for a 360° look at penny stocks, I thought.

What are penny stocks?

There is no fixed definition to be applied, unfortunately. Many consider a stock trading below $5 to be a penny stock. Others define a stock as a penny stock if its market capitalization lies between $50 million and $300 million. In yet another classification, if a stock trades other than on the major exchanges it’s a penny stock.

For a practical and simple definition I suggest that any stock trading on the Pink Sheets or on the OTCBB be considered a penny stock.

Typical characteristics of penny stocks

The common traits of penny stocks are:

  • These are usually small companies with poor liquidity in trading.

  • Highly speculative.

  • Poor disclosures and availability of financial information.

  • Lack of pedigree – they may be rank newborn companies or could be in bankruptcy proceedings.

  • Lack of compliance requirements and hence poor standards of supervision.

Pitfalls

Because of these traits investors are at a handicap for making proper evaluations of the quality of the company.

The inadequate liquidity is a cause of fat bid-ask spreads and prohibitive transaction costs, and also makes it easy for scamsters to manipulate prices. Investors may also find it difficult to exit a penny stock in the absence of trade volumes.

Inadequate surveillance makes it easy for crooked company promoters and fraudsters to set up the aforesaid pump-and-dump scams. Unscrupulous penny stockbrokers also try to offload dud shares on unsuspecting investors through various ‘free’ recommendations, cold calls and high-pressure Internet marketing and email campaigns.

Sometimes penny stocks just disappear due to delisting or bankruptcy liquidation.

Penny stocks – the other side of the coin

Lest you think that penny stocks are a surefire way to be scammed and lose money, let me present their flip side – they are not all bad!

  • Though penny stocks are very risky, they also have great growth potential and can turn out to be tremendous profit opportunities. A wise penny stock investment can provide multi-bagger returns over a short period of time.

  • In fact penny stocks are a proxy for America’s huge base of small enterprises.

  • Penny stocks are a great way to learn investing with a small capital amount.

  • Penny stocks also allow the opportunity for a very small investor to hold shares in a promising company.

  • In recent times, the authorities have taken strict steps to weed out scams, investors have become more mature and penny stock investing is no longer as dangerous as it used to be.

  • An investment in penny stocks can be a small, but useful, means to diversify your portfolio.

Here’s a chart of a penny stock that did well and ‘graduated’ on July 14, 2011 from the OTCBB to the Nasdaq Capital Market.

MITK Mitek Systems
MITK Mitek Systems

Navigating penny stocks – the dos and don’ts

Do:

Get an education by reading up and accessing the resources available on the Internet and through books and newsletters. If you are a very new investor, there is no harm in creating and tracking a ‘paper’ portfolio that can give you a feel for investing without risking money immediately. Take the time and effort to carry out your own due diligence and analysis of the stock before you invest. Go for stocks that have good liquidity, are in a confirmed uptrend and are profit-making companies with cash flow. When you start, ensure that you have risk management in place – have an idea when you will bail if the stock tanks, and when you would cash in profits if it takes off. Stick to these levels. Get a good, reputable broker.

Don’t:

Act on tips, rumors on the street, spam emails and ‘free recommendations’. Don’t risk a large amount on penny stocks – certainly not money you can ill afford to lose.

If you want to profit from penny stocks, it’s crucial that you keep your brokerage costs as low as possible. You’ll be trading often so high trading costs can have a huge impact on your bottom line. I personally use Ally Invest and they are AWESOME! They offer low prices and great support with the best online trading platform.

Unfortunately Ally Invest is US only. TradeStation is the best online brokerage for Traders outside US.

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