Penny Stock Dangers

Penny stocks are considered highly speculative investments.
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Penny stocks are shares of small companies that trade at prices ranging from less than one cent to approximately $5. Although these stocks seem like a great way to buy large amounts of stock inexpensively, they can be a danger both to an investor and to the company that issues the stock. The over-the-counter market, where penny stocks trade, is largely unregulated. Companies can voluntarily publish their disclosure documents through OTC Markets in cooperation with the Financial Industry Regulatory Authority (FINRA), the regulatory body that covers trading and issuance of stock. But many companies choose not to report their financial returns, important developments, insider transactions and press releases. Disclosure documents such as quarterly and annual reports protect both the investors and the issuing companies.

Pump and Dump

A hallmark of penny stock trading is the pump-and-dump. When an issuing company hires a stock promotion firm to publicize the company's good qualities and potential, payment is often made in hundreds of thousands of shares of stock. The stock promoter emails investment alerts claiming the stock is about to rise in price, posts positive comments about the stock on online stock bulletin boards and calls potential investors. When the stock price has risen, the promoter sells his stock quickly, often causing the stock price to drop significantly. This tactic poses a danger to unsuspecting investors who buy stock at pumped-up prices, only to watch it fall significantly in price when the promoter dumps his shares on the market. Good companies are sometimes forced to use stock promoters to get their stocks noticed, but too much use of these tactics can destroy a company's credibility with investors and result in a drop in the stock price to under 1 cent, where it can remain for years until credibility is restored. Penny stock investors often get caught in these situations because they don't recognize a pump-and-dump situation until large blocks of stock for sale suddenly drive the stock price down.

Equity Credit

Sometimes a small, public company needs money and can't borrow it at the bank or attract venture capital. One way it can get money is by selling its penny stock at a discount to large stock traders. These traders also operate pump-and-dump tactics, which result in attracting buyers to the penny stock. These tactics hurt the penny stock investor, who loses money and might get stuck holding a nearly worthless position for years. They also hurt the issuing company that dilutes its shareholders through the issuance of large blocks of new stock to these traders. Dilution tends to lower the price of the stock. These tactics are common in the penny stock marketplace because the traders who buy discounted stock from small public companies don't want to take the risk of holding it long term, so they pump up the price and sell out as quickly as possible. They take advantage of penny stock investors who, in many cases, are attracted by the low price of the stock and the glowing hype, but don't do their research into the fundamentals of the issuing company, and don't realize they are buying into a pump-and-dump operation.

Reverse Mergers

Penny stock issuers tend to be small companies, and many of them go out of business. This is a risk penny stock investors take when buying stock that is not subject to SEC reporting requirements. Reporting requirements seek to keep shareholders informed of the true financial strength of companies. When a publicly trading penny stock company fails, one of its assets is its legal trading shell, which it can transfer to a new company through a complex transaction called a reverse merger. Many currently trading penny stocks are the result of reverse mergers because it is a quick and relatively inexpensive way for a small private company to go public. The SEC has taken steps to try to curtail IPO reverse mergers because of the risk they represent to the investors and to the new company occupying the shell. These risks include undisclosed liabilities from the previous occupants of the shell, which can put the new company out of business. The reverse merger transaction can also hurt investors by creating large blocks of stock held by people who plan to dump the shares on the market to take their profits, causing a significant decline in the stock price. Check the initial disclosure document for the history of the company. If one or more different companies are listed as having traded under the registration, the company has gone through a reverse merger.

Reverse Splits

Another tactic common to the penny stock market occurs when a small company has exhausted its supply of authorized stock. This means it has no more stock to use to pay promoters and can't sell stock for equity credit. The company can replenish its stock by doing a reverse split. A reverse split is damaging to investors because it dilutes their percentage ownership and reduces the number of shares they hold even though it increases the price of those shares. For example, if a company has 500 million shares issued, it can choose to do a 1-for-50 reverse split. If the stock price is trading at one cent prior to the split, it will trade at 50 cents after the split. However, an investor who owns 5,000 shares prior to the split will own only 100 shares, post-split. Sometimes reverse splits are beneficial if they are done to raise the stock price so the stock qualifies to trade on a higher exchange. This benefits the stockholders since a higher exchange entails disclosure according to SEC rules and regulations.

Lack of Liquidity

Many penny stocks trade sporadically. When stocks that trade on higher exchanges are thinly traded, there is usually a specialist who will buy the stock. There is no market at all for many penny stocks because only a few brokerage firms allow their customers to trade penny stocks. Because penny stocks are highly speculative, traders react to news that fuels speculation. There will be a period of hot buying activity when good news comes out. But when there is a lag in news releases, there might be many days when the stock does not trade at all. Unless there are buyers for the stock you hold, you might not be able to sell it when you want. Never invest in penny stocks with money you can't afford to lose or might need in the foreseeable future.

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