Although trading penny stocks has the potential to be a richly rewarding experience, there is a great deal of risk involved. Suffice it to say, trading in the penny stocks require a considerable amount of caution. Many of these smaller penny stock companies are on the verge of filing bankruptcy while other companies are so new that finding any credible information about them is extremely difficult. Therefore, it pays to know as much about a particular company before you invest any money in it.

Penny Stocks – The Real Scoop

There are two options for trading penny stocks, namely the Over-the-Counter Bulletin Board (the OTCBB) or Pink Sheets. You should always approach these exchanges with a great deal of caution since the SEC doesn’t require that they file with them. In addition to this, the lack of credible information makes it difficult to formulate any kind of decision as to which company is the better choice of penny stock to invest in. Finally, be aware that no minimum standards are imposed by the OTCBB or Pink Sheets for companies that want to maintain their listing.

7 Penny Stock Scams to be aware of

For several years now, the SEC has viewed penny stocks as the bane of the investing and trading world. This is due to their lack of company histories, credible information, liquidity, and minimum standards. Consequently, penny stocks have become a viable target for con artists and scammers. These criminals deceive inexperienced people by enticing them into investing their money in stocks that are cheap or totally worthless. Below are the 7 most common penny stock scams to be aware of and avoid.

“NO net sales” scams – when the scam artist stipulates that a specific amount of time must pass before you can sell your penny stock shares, this is known as a “NO net sales” scam. Investors are duped into believing that there will be a large, ongoing demand for this particular stock, but end up losing everything.

Guru Scams – these types of ads are very common and show the inexperienced investor how an individual referred to as the expert or “Guru” struck it rich using a secret investment formula to become successful. In most ads, you will see the person next to an expensive vehicle, in a boat, or sitting on the deck of their fancy lakeside home. He or she promises to share their secret with you for an amazingly low, one-time sum of money. Any time someone refers to themselves as an expert or Guru, RUN!

Mining scams – diamonds, gold, and oil have always been some very enticing investments. The Bre-X scam of 1997 was one of the most famous scams on record. Speculation on this stock rose dramatically when company owner David Walsh falsified information regarding a massive Burmese gold mine being worth $4.4 billion. Sadly, most investors lost every penny when this company went bust.

Offshore scams – according to the SEC, companies operating outside the US are not required to register stock shares when selling them to investors. The average penny stock scammer loves this scam because they can purchase cheap, unregistered shares of stock and sell them to American investors . . . at an inflated price of course. As a result, these unregistered stock share prices drop because of the influx of them. The scam artist make most of the profits while the investor earns little if any profits.

Pump-and-dump scams – as one of the more common penny stock scams, you typically find them in FREE investing and trading newsletters. Promoters entice the inexperienced investors into buying up shares, thereby pumping up the price. Once the price gets high enough, scammers dump or sell them for huge profits and leaving the unsuspecting investor high and dry.

Reverse merger – in order to avoid the expense and hassle of following the proper procedure, some private companies will merge themselves with public ones. In doing so, the new company can easily falsify its earnings history in order to inflate the price of its stock shares. Granted, there are some reverse mergers that are legitimate. You can always spot the bad ones by researching their history for any questionable activity.

Short-and-distort – this is the opposite of the pump-and-dump. The scammer employs short-selling to generate a profit. Shorting is effective when investors borrow stock shares and dump them immediately at a higher price. The scammer spreads false, damaging rumors about the company so the stock price drops. He then gobbles up the shares that have been sold at a lower price and returns for a tidy profit.

How to avoid being a Victim of a Penny Stock Scams

While some investors have done well trading penny stocks over the years, no one is immune to the corruption, fraud, and market manipulation that occurs on a regular basis in this investment arena. However, these abusive practices are by no means exclusive to the penny stock domain. Taking this into consideration, how does one avoid being the victim of a penny stock scam? Here are 5 steps you can take to protect yourself:

Be sure that the company’s business plan is realistic – does the company have the assets it claims to have? Is their business plan realistic and achievable? Remember the example of Bre-X above and how it was a huge fraud. Approximately $3 billion in Canadian dollar market value was wiped out when that company collapsed.

Determine if the company’s management is credible – the success of any company depends in large part on the credibility of its management and penny stock companies are no exception to that rule. You’re not going to find an Elon Musk or a Richard Branson running these companies, but you still need to investigate them.

Evaluate the company’s financials – normally, you won’t find a lot of current, in-depth information furnished by many penny stock companies. However, you should still look for their financial statements and evaluate them. Thorough scrutiny could reveal if there are outstanding liabilities and substantial debt as well as their net cash flow. Look for recent, large revenue growth as this is a positive sign.

Look for the quality of disclosure – this is the primary indicator of a company’s transparency. So the more disclosure that’s apparent the better off the investor will be. Obviously, you should avoid all companies with little if any credible information. The age old adage “Caveat Emptor” – Let the Buyer Beware – applies with penny stocks.

Understand how promotion and research differ – promoters will have lush reports written by newsletter authors, many of whom can be very convincing. Deliberate distortion and outlandish projections are commonplace in many cases. So you have to understand the difference between promotion and legitimate research. Read the disclosures . . . if there are any.

Knowledge is power and definitely the key to successful penny stock trading. At Investors Hangout, you’ll find numerous forums and message boards relevant to buying and selling stocks. To learn more, visit our website today.