The Insider's Guide to Penny Stocks!

In my 15 years as a professional trader, I have had my fair share of "experiences" with penny stocks. Most recently, I have been receiving a lot of questions regarding this market in the online investing course that I teach. I suppose that with the recent challenges we have been facing in the economy, folks are looking to do just about anything to make money and recoup losses. Here's what you need to know before you invest your hard-earned dollars in this nebulous market.

There is a lot of confusion out there about what qualifies as a penny stock. The SEC's own website is very general and therefore leads to a lot of misinformation.   What this does is opens the door to the less-than-honest participants in this marketplace (more on this later).    Technically, under the SEC definition, General Motors (GM) is a penny stock because its stock is trading under $5.00 and may or may not trade on an exchange (it does!).  GM also happens to be a member of the Dow Jones industrial Average (DJIA).   So which is it?

The true way to determine whether a stock is a penny stock or not is to look at where it trades, and NOT what its price is! Let's face it; there are a lot of reasons why a stock may trade under $5.00. The stock could be in distress, it could be a small-cap stock, or it could be a penny stock. 

The difference between these 3 examples is that the first 2 trade on exchanges, where there are listing requirements. This leads to more financial transparency and regulation and oversight. The third example, penny stocks do not have these requirements as they trade over-the-counter or OTC. And this is where the danger lies. Not with the price of the stocks, but with HOW they are traded.

Penny stocks that are traded OTC are usually traded in 2 venues: the OTC Bulletin Board or the Pink Sheets. These markets lack transparency, regulation and are inefficient in price discovery. And they are not affiliated at all with the NASDAQ marketplace. Scammers will attempt to make this connection to increase credibility. Typically, the stocks that trade on these venues have very low volume and the spreads between the purchase and sale price (bid/ask) are quite wide. It is for these reasons that these markets get a bad rap, and deservedly so. 

In Part II of the article, we will examine in great detail the different ways that market participants can take advantage of unsuspecting investors and how investors can protect themselves.

So why do investors continue to speculate in a market that is questionable to say the least? For some, the promise of a tremendous payout if the penny stock goes up is greater than the risk or potential loss they might face.    Others have received a "hot tip" on a new company and think to themselves, "What's the big deal, I'm only going to risk a small amount."   And this is where the trouble starts. This is why I refer to buying penny stocks as "playing the lottery". Because buying them really is a gamble. 

Newsletters, fraudsters, and stock touts or promoters are but a few of the participants who give investing in penny stocks a bad name.  These unscrupulous players prey on the greed of the investor, and often times the investor will lose in a classic case of "pump and dump".

Be sure to check out Part II of the article which reveals how the penny stock scams operate and how to protect yourself from them.