What is the first thing that jumps to mind when you hear the words “penny stock”?
Get rich quick! Opportunity!
Excitement! Investing in the next Big Thing!
Handle with care! Danger!
Let’s take a look at the optimistic view of penny stocks, let’s take a look at the
pessimistic view of penny stocks, and show you how to avoid being the sucker in penny
stock trading.
Penny stock upside.
Here’s a penny stock currently trading at only 4 cents per share.
If it goes up by just one penny, which could happen any day now, you’re looking at a
25% gain.
And once it hits 10 cents, you’re up 150%.
How does a 150% return on your money sound to you?
Yeah, that DOES sound great!
And 4 cents per share is pretty affordable, right?
What a penny stock sales pitch doesn’t mention, or mentions only in passing, is that there
is also huge downside potential to this penny stock.
If it goes down by just one penny, you’re looking at a 33% loss.
And once the penny stock hits 1 cent, you’re down 75% from the 4 cents you started at.
Penny stocks are a risky business.
Why would people focus so much on the upside potential?
Well, there’s a lot of money to be made in penny stocks, but not necessarily for you
as an investor!
A great way to learn how penny stock trading works,
is to watch the movie “The Wolf of Wall Street”.
Jordan Belfort and his team of brokers are selling penny stocks at 50% commission,
and they soon find even more ways to make lots of money.
Like manipulating share prices in an IPO, but that’s a different story.
Here’s the Wolf’s penny stock sales pitch on Aerotyne International: “It's a cutting
edge high-tech firm out of the Midwest awaiting imminent patent approval on the next generation
of radar detection that has both huge military and civilian applications.
The key to making money in a situation like this, is to position yourself before the event.
Because by the time you read about it in the Wall Street Journal, it’s already too late!
The only problem you are going to have with this stock, is that you didn’t buy more!”
What Jordan doesn’t mention is that the Corporate Headquarters of this penny stock is….
A shed.
And that the potential of this as-yet-unknown company is probably never going to materialize.
Not all penny stocks are “unknown” companies though, some companies that have turned into
penny stocks used to be quite successful.
Sears Holdings Corporation became a penny stock.
The fact that it is a penny stock now should tell you the most important thing about the
company as it exists today: it is dying!
It filed for bankruptcy in 2018, and sold its assets in 2019.
All that’s left is a shell company.
The main purpose of this video on penny stocks is to teach you how not to be a sucker.
It is important to understand how an illegal “pump and dump” scheme works, to avoid
getting suckered into it.
Here’s a typical penny stock share price graph.
Usually trading at, you guessed it right, a few pennies.
Here’s what “pump-and-dumpers” do: step 1 they buy shares of very low-priced, thinly
traded stocks, step 2 they spread false or misleading information to pump up the price
(or pay somebody else to do this for them, to create a smokescreen around their identity).
There’s no guarantee for a “pump and dumper” that his misleading information gets picked
up and spread around social media and chatrooms.
If it doesn’t, he just writes another piece of misleading information and hopes that that
one will work.
If it does work, then they go to step 3: they dump the shares once the price peaks.
Big gains for the “pump-and-dumpers” (buy low and sell high, with an illegal high that
you created yourself), big losses for unsuspecting investors that fell into the trap.
Let’s take a look at how to detect this false information that is spread on penny
stock promoter websites, investor forums, and social media.
The inputs for a penny stock alert are a piece of paper, and the realization that the attention
span of the average human being has dropped below that of a goldfish, who are not exactly
known for focusing on one thing for a very long time.
Write an attractive headline in big font using exciting words like expectation or anticipation.
It needs to grab people’s attention, so everybody reads it and clicks on the link.
Then write a medium sized “business case” section around the possible deal that the
company might be involved in.
About 800 words, not too short, not too long.
Make this “business case” include references to some big brand name, a big company, or
a celebrity, and make it sound sufficiently sophisticated by talking about things like
reverse mergers, stock splits, dilution, all that good stuff.
Most people will browse this part of the news release, but not read it in too much detail.
Then write a huge disclaimer of around 3000 words, to try to keep yourself out of legal trouble.
Neither human nor goldfish is likely to read this disclaimer section, even though the best
information is right there!
Here are some excerpts from the disclaimers in actual penny stock alerts that should teach
you to be very careful: “We caution that these sorts of deals in
penny stocks are often canceled or found to even be entirely untrue but we do also have
to maintain that if the deal is completed……”
If you emphasize “but” and “if”, it brings out the gambler in people and they
will probably ignore the caution.
“We are engaged in the business of marketing and advertising companies for monetary compensation”.
Yes, you heard it right, the penny stock promoter actually spells out the fact that he is getting
paid for writing these on behalf of somebody else!
“Trading activity and stock prices in many if not all cases tend to increase during the
advertisement campaigns of the profiled companies and in many if not all cases, tend to decrease
sharply thereafter”.
Excellent description of how “pump and dump” works, right there in the disclaimer!
So train yourself to lengthen your attention span beyond that of a goldfish, sign up for
a few of these penny stock promoter alerts (for entertainment purposes)
and read those disclaimers!
Some penny stock traders try to outsmart “pump and dump” schemes, and use the penny stock
promoter alerts for more than just entertainment purposes.
Step 1 sign up for penny stock alerts, step 2 watch the stock go up and “short sell”
at the peak.
Short selling involves borrowing shares from somebody else, selling those, and buying shares
at a later stage to close out the borrowing position.
Step 3 buy back the stock once it drops, close the short position.
Basically, these penny stock traders try to sell high and buy low, making money riding
the downward wave of the “pump and dump” pattern.
There is a big risk involved here, which is the second half of step 2: how do you short
sell at the peak?
First of all, as these are thinly traded shares, there might not be enough shares (or even
ANY shares) available to go short.
Second, how do you know (except with the benefit of hindsight) that the share price reached
the peak?
You may not get to step 3 if the share price continues to rise after you took a short position.
You might even be facing an unlimited loss on your short position, get a margin call
from your broker, or blow up altogether.
Back to detecting penny stock pump and dump fraud.
You can learn a lot from actual cases that the Securities and Exchange Commission details
on its website, in a section called “spotlight on microcap fraud”.
This page has news updates on the SEC filing charges, so you can find out who is involved
in these and avoid doing business with them, as well as learn general lessons of how this
fraudulent activity works.
An example that the SEC gives of the effects of penny stock manipulation is “As alleged
in our complaints, elderly and unsophisticated investors have lost millions of dollars as
a result of these boiler room schemes.”
These are real people losing real money here.
The SEC also provides a very useful list of potential red flags that help you detect possible
trouble when you do the right research prior to making an investment decision!
Where do penny stocks fit into the stock market?
A common way to talk about the size of companies is to categorize them by market capitalization.
Market capitalization is the market value of a company based on the total value of all
its publicly traded outstanding shares.
You simply take the number of outstanding shares and multiply it by the share price.
Mega cap companies are companies with a market capitalization
in excess of one hundred billion dollars.
Companies like Amazon, Apple, Exxon Mobil, Facebook, Google, Johnson and Johnson, Microsoft.
These are companies that are in the financial news very often, with a solid financial reputation
and a long history, and actively traded shares.
Penny stocks are in the opposite category.
Not large cap, not medium cap, not small cap, but micro cap or nano cap.
Pretty much every respected financial news outlet ignores stocks under one hundred million
dollar in market cap, they simply do not want to risk their reputation
in talking about them.
There are many micro or nano cap stocks (big circle),
some of these are penny stocks (small circle).
The small circle (penny stocks) only covers a part
of the big circle (micro or nano cap stocks).
Almost all penny stocks are micro or nano cap stocks
(the area where the two circles overlap).
Most of the small circle (penny stocks) is within the big circle (micro or nano cap stocks).
Micro or nano cap penny stocks typically have limited assets and operations.
There are many stock manipulation schemes (big circle),
some of these involve penny stocks (small circle).
The small circle (penny stocks) only covers a part of the big circle
(stock manipulation schemes).
The vast majority of penny stocks are subject to stock manipulation
(the area where the two circles overlap).
Most of the small circle (penny stocks) is within the big circle
(stock manipulation schemes).
Penny stocks are generally considered speculative investments.
Penny stocks seem to have seductive upside potential,
but also carry dangerous downside risk.
As you probably figured out from this video, I don’t trade or invest in penny stocks.
There are much safer and more stable ways to invest.
Want to learn more about finance and investing?
Then subscribe to the Finance Storyteller YouTube channel!
Thank you.