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The Dangers of Penny Stocks

Jan 15, 2008
There are several reasons why it is dangerous to trade penny stocks. These stocks can seem very attractive to beginners so please read the warnings below.

Definition:
Penny stocks are defined as stocks with a price per share of less than five dollars (or one dollar in some cases). Many of them trade on the OTC/BB (Over the Counter, Bulletin Board) stock exchanges, where they are sometimes known as Pink Sheet stocks, and they might have symbol extensions like .PK or .OB.

Volatility:
A typical "blue-chip" stock with a price of twenty dollars will typically only fluctuate by one to two percent per day while a penny stock could easily go up or down ten or twenty percent or more. In fact, it is not uncommon to lose eighty percent of your investment within a week!

Scams:
"Alert! XYZ is at $0.024 and is expected to hit $0.35 at the end of the week!"
You have probably received several emails like this. Penny stocks are subject to frequent spam email attacks.

In the classic "pump and dump" scheme, a person or company will buy some stock and then email many people telling them that stock is going to go up a large amount. Many readers of this email will then buy that stock, causing its price to go up dramatically because of the law of supply and demand. Once the stock price has gone up, the scammer will sell his or her shares for a sizeable profit. The stock price will then usually drop back down significantly because the stock was overvalued. This results in many unsuspecting investors losing lots of money. This is a very common problem and the Securities and Exchange Commission actively tries to detect these scams and charge these criminals.

Limited Information:
For many penny stock companies, there is very little information available online. This is due to the fact that many of them trade on the OTC/BB exchanges, which do not require extensive reports to be available to the public. Without the appropriate information, it is very hard to make solid investment decisions.

Conclusion:
Now that you have a better idea of what penny stocks are and how dangerous they can be, please be careful as you move forward with your trading strategies. You do not have to stay away from them completely. In fact, I recommend you try a couple of them using a small amount of money, just to "scratch your itch" and see for yourself.
About the Author
Nicholas Swezey is the creator of the Free Stock Market Game at HowTheMarketWorks.com.
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