Penny stocks can be attractive for new investors due to their low prices and promises of high returns. However, just as penny stocks can make investors money, they can also cause losses. This is especially true for new investors who don't have a thorough understanding of how penny stocks work. New investors must do their due diligence with every stock they invest in.
Understanding the Spread
Federal law requires sellers to disclose the offer, or "ask," and bid values of a stock, along with the sellers' compensation for making the trade. The offer refers to the price the seller charges the investor to purchase the stock, while the bid refers to how much an investor can sell share shares of stock for. The difference between the offer and the bid is referred to as the "spread." The spread is important to penny stock investors because it determines the profitability of the stock. For example, if an investor purchases a stock at a half-cent bid and a one-cent ask, the stock needs to double in value before the investment breaks even. Brokers and dealers often mark up penny stocks by charging a few percentage points over the spread to compensate themselves for keeping sufficient inventory for investors. If the seller charges a mark-up on the stock, this compensation must be factored into the equation. Since penny stocks are often sold by small start-up companies trying to raise capital, these low-cost stocks can provide significant returns if the company takes off. Investors are often willing to pay an ask price that's somewhat higher than the bid price if they believe there's a good chance the stock will be worth much more in the future.
Manipulation of Penny Stocks
Penny stocks can be manipulated. According to the Missouri Secretary of State, a common manipulation of penny stocks occurs when a broker purchases a large volume of penny stocks at a low price and then uses high-pressure sales tactics to create hype around the stocks to increase demand. As a result the stock prices rise until no more are left. When the bottom falls out, investors are left with worthless stock. On occasion brokers may repurchase these stocks at the low prices and repeat the scenario again. In the industry this is referred to as "pumping and dumping." Stock tip newsletters and communications can be suspect. Often disclaimers on these publications reveal that the authors are being paid to promote the stocks, which results in a conflict of interest at the investor's expense.
Certain warning signs indicate that something fraudulent may be going on with a particular penny stock. One thing to watch out for is high-pressure sales tactics by brokers. Since penny stocks are most commonly offered by emerging companies, their stocks are considered long-term investments that build value over time. New investors shouldn't feel pressured to buy anything immediately; pressure to do so is a warning sign that something may be amiss. Investors should also watch out for unauthorized activity on their accounts. Unscrupulous brokers have at times temporarily parked stocks in unauthorized accounts to meet sales quotas. Investors should avoid investing in penny stock companies that don't disclose exactly how the investment money will be spent; failure to disclose is a red flag.
Research and Diversification
Penny stock investors should conduct thorough research on each of their investments by learning as much about the companies as they can. Investing should be treated as a second job; having patience can help investors avoid getting carried away and overtrading, which can result in costly mistakes. Having a diversified portfolio is important. The key to diversification is to make sure a portfolio has investments of varying different risk levels. According to Penny Stock Pick Alert, investors should never keep more than 20 percent of a portfolio in penny stocks, or too much of their capital is put at high risk.
- Securities and Exchange Commission: Important Information on Penny Stocks
- Missouri Secretary of State: Penny Stocks a Guide for Beginning Investors
- MoneyShow.com: 10 Tips for Trading Penny Stocks
- Stock Rock and Roll: The Best Stock Advice for New Investors
- Money Crashers: Penny Stock Investing for Dummies – 4 Tips for How to Buy & Research Penny Stocks