Investors should be aware that although most penny stocks and penny stock issuers are as legitimate as are large-cap equities and companies, there are indeed certain increased risks associated with trading in penny stocks. For the most part, these risks derive not from the simple fact that the stocks in question are penny stocks but rather, from the manipulation that these stocks may be susceptible to on the part of unscrupulous promoters or large-block investors attempting to influence share price and volume. Let’s take a closer look at these risks, and how even a beginning investor can learn to spot the signs of a potentially risky penny stock transaction.
It’s important to first clarify why it is that penny stocks may be particularly prone to such manipulation.  The ability to manipulate stock price and volume is not necessarily a factor of the penny stock issuing company’s start-up status, or of the fact that the stock in question may be listed on an Over-the-Counter exchange, rather, the ability to manipulate share price is a direct function of the stock’s low share price and high volatility. These factors, coupled with the looser oversight typical of the lesser exchanges (in terms of reporting requirements, number of shareholders and average volume of traded shares) makes for a climate that could lend itself to unscrupulous machinations if company management, stock promoters or related parties were so inclined.

PennyStock Trading

Stock scams that could cause legitimate investors to lose their capital investment can generally be divided into two categories, namely, those that are perpetrated by individuals who have a fiduciary relationship with the issuing company, and those that are perpetrated by those who have a fiduciary relationship with the investor. In each case, of course, the implied fiduciary responsibility is broken. The first category includes fraudulent actions undertaken by a stock promoter (typically hired by the company), by a member (or members) of company management, by a single shareholder (or group of shareholders) holding a large block of the company’s stock, or by some combination of these characters. These are the most likely perpetrators when a company’s stock is the focus of a so-called “pump and dump”, which occurs when highly positive spin about a company and its prospects is widely disseminated, whether through the internet, through junk faxes or through a barrage of telephone calls made from stock promotion boiler rooms, with the intention of generating enough interest on the part of retail investors that the stock’s share price and volume dramatically increase. Once the stock has been successfully “pumped” to a higher share price, these fraudsters begin the “dump” phase of their machinations, wherein they divest themselves at this higher price level. The cumulative effect of the dumping of their holdings serves to lower the stock’s share price to its former level, if not lower; investors who bought into the positive hype and purchased their shares at the height of the “pump” wind up losing their investment.
Another such scam typically perpetrated by the same group or groups of individuals is the so-called “poop and scoop”, which, essentially, is the inverse of the pump and dump: in a poop and scoop, highly negative information is disseminated in order to cause selling by nervous shareholders, resulting in a lowering of share price; promoters and other “insiders” or related parties then purchase the shares at this lower price level and wait for the good news, that they know will soon be released, to become public. Investors who are unaware that the stock will rebound after the “scoop” phase is completed will likely sell their shares when the price starts dropping, in an effort to minimize their losses, missing out on the coming gains.
Penny stock investors also face risk the risk of having their shares lose significant value through dilution. Dilution occurs when company management authorizes the issuance of millions of additional shares of stock, lowering any single investor’s holdings to a fraction of their former value prior to the dilution. While dilution is a legitimate practice and not necessarily a scam, it is nonetheless a danger that the retail penny stock investor should be aware of. Large-cap companies listed on higher exchanges rarely authorize the issuance of additional shares in amounts large enough to significantly dilute their current shareholders’ value, but small-cap issuers frequently do, for a variety of legitimate reasons.
To minimize the danger of being caught up in a penny stock position that might turn out to be risky, be certain that you never purchase any penny stock without first having completed a thorough amount of due diligence. Investigate not only the company and its fundamental business, but also the stock’s history, paying particular attention to current and historic share price as well as to its trading volume over time. A stock that has seen no significant movement for an extended period of time yet begins to show dramatically increased trading volume may very well be the target of a pump and dump, and prudent investors will watch the trend over time to satisfy themselves that the upswing is legitimate before jumping in. Further, be wise and avoid purchasing any stock on the advice of a stranger, regardless of how “hot” the tip may ostensibly be, and never purchase stock on the basis of unsolicited promotions made over the phone or the internet. Your chances of significantly mitigating such risk are greatly increased if you simply rely on your own common sense and sound judgment.
Some penny stock-related investing dangers are caused not by those affiliated in some way with the company, but by those whose first loyalty should be to the investor: stockbrokers. Despite their status as licensed professionals, stockbrokers are only human, and there will always be a certain percentage whose ethics are less than ideal. The most common type of penny stock broker fraud is known as “front running”, which is a ploy to enrich the broker, or his preferred clients, at another client’s expense. Under a front-running scheme, a broker who receives an order from a client to buy or sell a significant amount of penny stock, and who correctly recognizes that the fulfillment of the client’s order will affect the share price in one direction or another, delays executing the client’s order until after he places his own order for either himself or his other client(s); by the time the broker gets around to placing the original client’s order, the markets will have shifted because of the broker’s own actions and the investor will have lost out.
Front running is only one of the many types of broker fraud which can be perpetuated in the small-cap marketplace. Another well-known broker-driven penny stock fraud is known as “circular trading”, wherein a broker sells a large chunk of a penny stock, fully aware that his likewise broker accomplice stands ready to place a purchase order for those same shares at the same time: by trading the block of shares back and forth between themselves, the brokers manage to create the impression of increased volume and share price. When legitimate investors who notice the upturn in trading volume show interest in the stock and buy in, the brokers sell and take their profit, leaving the retail investor holding the shares when the volume and share price drop back to their former levels.
In order to avoid getting caught up in a penny stock fraud perpetrated by brokers, make sure that your chosen broker (as well as his brokerage house employer) enjoys a good reputation with FINRA, the licensing authority. You can research his record to learn whether there may be any consumer complaints filed against him, and to learn whether his license is valid and blemish-free. Avoid doing business with brokers whose reputation may be tarnished, and make sure that you thoroughly examine any stock before purchasing, regardless of who may have made the recommendation.
The best defense against the dangers of risky penny stock trading is the implementation of good, thorough research habits and the reliance on sound judgment and common sense when making buy or sell decisions. Know your small-cap issuers before you commit your money to invest, and know the contents of your portfolio well enough to recognize the sell signals when they show themselves. Recognize that supposedly “hot” tips do not get widely disseminated: if they’re really that hot, they’re being snapped up by investors much closer to the company than you. Remain realistic, remain informed and remain aware, and you’ll remain untouched by danger.