Penny stock are common shares that trade for a very low value per share. Due to their low price, they can be appealing to novice investors, but they are considered high-risk. Due to a combination of market reasons, penny stock are prone to wide and unpredictable price swings, while simultaneously also being considered more likely to go through periods of market stagnation and low-liquidity. It is also worth knowing that pump-and-dump schemes often target penny stocks.
It is absolutely possible to make money from penny stock trading, but it is strongly advisable to do your own homework and study the market conditions and well-known pitfalls of penny stock trading before you get started.
If something seems to good to be true, it often is – especially in the world of penny stock trading.
U.S. Securities and Exchange Commission (SEC)
Within the United States, SEC and the Financial Industry Regulatory Authority (FINRA) has special rules pertaining to penny stock trading. Individual states can also have their own penny stock securities regulations.
The U.S. Securities and Exchange Commission (SEC) has their own definition of what a penny stock is, and that definition includes that it must trade below $5 per share. The criteria also includes factors pertaining to market capitalization and shareholder equity.
Important: In the United States, securities traded on a national stock exchange are not legally considered penny stocks even if they meet the other criteria. One notable example of when this rule became important was during the market downturn of 2008-2009 when the share price of several well-established stock companies fell considerably. For a while, Citigroup shares (NYSE:C) traded below $1, but were still not considered penny stocks in a legal sense as they were still listed on the New York Stock Exchange which is a national stock exchange.
Volatility
When a share is low-priced, it is possible for an investor to buy a significant number of shares without making a large investment. It is also possible for a single small-scale investor to suddenly flood the market with a significant number of shares in the company simply because he has decided to divest himself of them. These two factors promotes volatility for penny stocks.
Liquidity
Low liquidity is a common problem for penny stocks. This means that if you want to sell your shares, you might find it difficult to find a buyer, even if you are willing to go below the most recently known market price.
What is a pump-and-dump scheme?
Penny stocks are a popular choice for operators of pump-and-dump schemes.
A pump-and-dump (P&D) is a form of fraud where the operator uses misleading positive statements to boost the market price of something, such as a security.
This is one example of how it can work:
The operator buys a large amount of penny stocks in a company. Since they are so cheap, it is possible to buy a large amount without putting in a lot of capital.
The operator uses misleading positive statements to lure people into buying stocks in the penny stock company, either from the operator or on the open market. (Note: The operator will not sell all or even most of their own shares; they need to be saved for later.)
The market price starts to increase, and this serves to lure in even more investors (or make the original investors make additional investments), because the price increase validates the operator´s claims. Also, now when people have started to see the price go up, they get scared to miss out on a good thing if they don´t buy-in right now while prices are still affordable.
When the operator is satisfied with the price increase, he/she sells their shares for much more than they bought them for. This is the ”dump” part of the pump-and-dump.
When the operator has cashed in, there is no need for them to continue to promote the penny stock company. Also, they have flooded the market with shares during the dump-phase. Predictably, the share price tend to tank soon after the dump.
The basic mechanics of the P&D scheme are very old, and when we scratch the surface we can see notable similarities between 21st century Twitter-based scams and fraudulent stock promoters of the 18th century. Nowadays, it is very easy for fraudsters to reach a wide audience using online chat rooms, spam emails, investment newsletters, Twitter, Facebook, Instagram, etcetera. It is not very difficult to plant fake press releases online and make them seem pretty legitimate, and to put up a very serious-looking web site to back up your wild claims about a company, a new invention, and so on.
The de Maison case
For those interested in learning a bit more, one example of an interesting case that is worth looking into is the Zirk de Maison case. In april 2017, the United States Federal Bureau of Investigation (FBI) reported a story where a man named Zirk de Maison (a resident of California) had been found guilty of carrying out a penny stock pump-and-dump scheme.
This case was a bit more complicated than the classic penny-stock P&D, because de Maison and his associates had actually created new companies as shell organizations instead of simply inflating the share price of an existing stock company. In 2008-2013, the de Maison crew created five small public companies, who never did any business nor had any legitimate assets. They then began selling shares to investors. Their promotional campaigns included the use of fictitious names. Once the share prices had gone up considerably, de Maison and his co-conspirators sold off their shares at the inflated price. The mass selling caused a massive drop for the share price, and soon the market price was almost nil.