How to Trade Penny Stocks Without Getting Scammed
The question of whether penny stocks are a surefire way to get rich or an elaborate scam would depend on the investor you speak to. Regardless of the controversial reputation of these stocks, this asset class remains highly popular among aspiring investors. Trading penny stocks might make you rich, but this is only as long as you avoid a pump-and-dump scam, among other types of fraud prevalent among these types of stocks, knowing how to legitimately trade penny stocks without getting caught up in a scheme.
Why Are Penny Stocks Vulnerable to Scams?
The SEC defined penny stocks as any security that costs $5 or less. Formerly, these were referred to as pink sheet stocks since penny stocks were not listed in conventional stock exchanges. Penny stocks are considered a type of over-the-counter asset in modern times. The OTC markets are known for their vulnerability. Companies that sell penny stocks are not required to disclose financial information as rigorously as stocks listed on indexes like the NYSE. As a result, these stocks are highly vulnerable to fraud. When you don’t know very much about the finances of a company, then buying its stock becomes more of a gamble and less of an investment decision. It also leads investors to incorrectly estimate returns from a penny stock investment, according to studies. That’s what makes it so easy for scammers to artificially inflate the value of penny stocks to invoke a buying spree. Eventually, the price corrects itself, costing the buyer a lot of money. This is the classic pump-and-dump scam. To circumnavigate this type of scam, investors should understand how to evaluate the actual value of a stock. When the company isn’t disclosing its finances, here’s what you need to do to get a realistic price assessment:
Research the Company and Understand Its Product
Start by running a rudimentary background check on the company you want to buy penny stocks from. You can easily do this online by looking up business addresses, registration numbers, and establishing that the contact information provided is accurate. If there’s a problem with establishing an official identity for the business, then you are looking at a scam. Once the business passes the basic background check, move on to researching the product. What is the core business of the company? If it’s a product, is it already on the market shelves? A word of caution here: if you don’t really understand the product or the sector the business works in, move on. As Warren Buffet said, invest only in products you understand. Once you know what the product is all about, and you still want to invest, go ahead and contact the business for financial information. At the same time, check the business name against any reports that might be filed with the SEC. The aim of researching the business is to grasp that it is, in fact, legitimate and has a viable product.
Ignore Promotional Content
It’s crucial that you do your own research to understand an OTC business and what it does. Investors should never trust claims about the business made in chain emails, advertisements, sponsored “reports,” and similar content promoted by a third-party or by the business itself. Scammers often use promotional tactics to pump worthless stock. Instead, look through official channels like legitimate news websites and SEC documents to understand the business. If anything seems shady, don’t bother with the stock and move on to something else.