In the world of stock trading there are few alleyways and avenues with a worse reputation than penny stocks. In large part, penny stocks owe this bad reputation not to anything inherently flawed in their nature, but to the plethora of shady characters dealing on the market. In the following lines we will try to cut through the noise and see what are penny stocks, why is the penny stock market such a magnet for all sorts of scam artists and morally challenged brokers, and what might constitute as safe practices in a fairly unsafe corner of the stock market.
What are penny stocks?
While there are no universally accepted parameters that define a penny stock, in broad terms, we are basically talking about low value stocks sold outside of the major stock markets, with the value cut off line usually placed around the 5$ mark. The market is mainly constituted of startups and smaller businesses. The main draw of penny stocks is the ability to enter the stock market game even with small investments. Dealing with penny stocks is a high risk – high reward game, with the participants buying low value stocks and hoping their value will dramatically increase. On the flip side there is a significant risk of companies going under and the value of their stocks plummeting.
Why are penny stocks considered “shady”?
Have you seen “The Wolf of Wall Street”? The plot of the movie revolves around various machinations on the penny stock market, and the film’s main protagonist Jordan Belfort (a real life character portrayed in the film by Leonardo DiCaprio) is probably the best known example of the shady characters operating on the penny stock market.
Belfort ran the world’s biggest “pump and dump” scheme, where he and his partners in crime would buy large volumes of stocks, thus artificially inflating their value, and then selling them off in a hurry, leaving other naive investors with worthless stock bought at an unrealistically high price.
Jordan Belfort of cinema was portrayed as a happy-go-lucky modern day version of Robin Hood who stole from the rich and gave… well, to himself and his associates, but there are many others who didn’t buy the romanticized version of Belfort. Penny stock expert Tim Sykes has no kind words for Belfort (“scumbag” is his characterization of choice) or any other scammer manipulating the market. Sykes has been calling for total trader transparency in an attempt to clean up the market, highlighting its biggest issue: lack of reliable information.
According to Tim’s site, somewhere between 80 and 90 percent of penny stock traders are losing money, in large part due to various speculations and manipulations present on the market. From promoters spreading fairy tales about their overnight fortunes to companies looking to inflate their value or raise their profile, there is too much false information and no reliable ways to separate fact from fiction.
How to avoid the risks of penny stocks?
Even without the myriad of shady characters involved, the penny stock market would still be a high risks playing field. Its inherent volatile nature is rooted in the uncertainty of any startup’s failure or success. The information is sparse, and patterns are difficult to predict. Experts like Sykes suggest seeking out companies with sustained increases in earnings over longer periods of time, and avoiding stocks which are low in value and which aren’t traded in large daily volumes. Extremely low value stocks are not worth the risks, while the stocks which are moved in lower volumes will be difficult to get out of should they suffer a decrease in value.
The golden rule of successful penny stock trading is “don’t trust anyone” – whether it’s the companies tooting their own horn or various promoters either selling their own instant success story, or pointing you in the direction of certain stocks and promising huge returns. Instead, rely on your own research and try to gather as much information as possible. If things don’t go as planned, don’t hesitate in cutting your losses and moving on.