Finding False Gold in Penny Stock

As far as traders go, many do not see the penny stock as a solid way to do business. Many believe that dealing with penny stock is a risky business. And it really is. Some traders think that the next Microsoft and Walmart stock is buried in a penny stock, which is why they stick around trading unknown stocks over the market.

What is a penny stock? According to the Securities and Exchange Commission (SEC), any stock under $5 is a penny stock. Definitions can vary; some set the cut-off point at $3, while others consider only those stocks trading at less than $1 to be a penny stock. What makes a penny stock risky? Certain issues must be considered before you decide to buy a penny stock:

1. Lack of Information Available to the Public - the key to any successful investment strategy is acquiring information to make informed decisions. In dealing with penny stock, information is much more difficult to find. Much of the information available about a penny stock is typically not from a credible source.

2. No Minimum Standards - Stocks on the OTCBB and Pink Sheets like the penny stock do not have to fulfill minimum standard requirements to remain on the exchange. Sometimes, this is why the stock is on one of these exchanges. Once a company can no longer maintain its position on one of the major exchanges, the company moves one of these smaller exchanges. While the OTCBB does require companies to file timely documents with the SEC, the Pink Sheets has no such requirement. Minimum standards act as a safety cushion for some investors and as a benchmark for some companies.

3. Lack of History - Many of the companies considered to be a penny stock are either newly formed or approaching bankruptcy. These companies will generally have a poor track record or none at all. As you can imagine, the lack of histories of companies only magnifies the difficulty in picking the right stock.

4. Liquidity - When a penny stock doesn't have much liquidity, two problems arise: first, there is the possibility that the stock you purchased cannot be sold. If there is a low level of liquidity, it may be hard to find a buyer for a particular penny stock, and you may be required to lower your price until it is considered attractive by another buyer. Second, low liquidity levels provide opportunities for some traders to manipulate stock prices, which is done in many different ways - the easiest is to buy large amounts of stock, hype it up and then sell it after other investors find it attractive

Penny stocks have been a thorn in the side of the SEC for some time because of the lack of available information and poor liquidity make these groups of stocks an easy target for fraudsters. There are many different ways these people will try to part you from your money, but here are two of the most common:

1. Biased Recommendations - Some companies pay individuals to recommend the company stock in different media, i.e. newsletters, financial television and radio shows. You may receive spam e-mail trying to persuade you to purchase a particular penny stock. Look to see if the issuers of the recommendations are being paid for their services as this is a giveaway of a bad investment and make sure that any press releases aren't given falsely by people looking to influence the price of a penny stock.

2. Off-Shore Brokers- The SEC permits companies selling stock outside the U.S. to foreign investors to be exempt from registering stock. These companies will typically sell the penny stock at a discount to offshore brokers who, in turn, sell them back to U.S. investors for a substantial profit. By cold calling a list of potential investors (investors with enough money to buy a particular stock) and providing attractive information, these dishonest brokers will use high-pressure sales tactics to persuade investors to purchase penny stock.

Be wary when investing on a penny stock. Chances are you will lose more money by putting your trust in a penny stock.

For more information on penny stocks check out the penny stock resource center