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About Penny Stock Risk

March 30th, 2010
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05.01.2010 update

Why You Should Avoid or At least Exercise High Caution Before Buying Penny Stocks: About Penny Stock Risk

Investor Education Series by Net Advisor

For two decades people have been asking me about buying penny stocks. I get real nervous when they bring this up, because I understand they want to buy low, sell high, and get rich with investing as little as possible.

The problem is if that this was easy to do then we would all be investing in penny stocks as opposed to buying shares in real companies such as IBM, Intel, Microsoft etc.

However, I still find that there are many, usually small investors with limited capital who like to “play” in low priced stocks. These are often stocks under $1.00, and often trading for pennies or less, and that they typically trade on the Over The Counter Bulletin Board (OTC BB) or “Pink Sheets.” These are stocks that do not meet the overall financial requirements to be listed on NASDAQ or the NYSE.

The thinking by small investors is that it’s a “ground floor opportunity.” I have seen spam emails hyping penny stocks that suggest that Wal-Mart or Ford were once a penny stocks. Both by the way are false statements. Wal-mart and Ford were NEVER penny stocks. Wal-Mart went public in October 1970 and offering 300,00 shares at $16.50 (source 1, source 2)

If you received an email, unsolicited phone call, or were referred to a website that makes a pitch of some hot stock that is about to take off, walk away. If the stock is a penny stock, run!

What may be happening is that there is someone with a vested interest in promoting the penny stock.

The penny stock promoter is frequently being paid in unrestricted stock and or cash, which I have seen up to the $100,000 cash range in their disclosure fine print. They use words to mask this payment, it is all about semantics.

The promoter writes letter, emails, publishes info on the net, makes phone calls by penny stock brokers, etc, all who are selling THEIR stock to EXIT the market as new unsuspecting new investors get in.

The stock can often soar in a short period because the trading volume (the number of shares being bought and sold) is dead (low) to begin with and even $1000 can skyrocket the “ask price” (what you pay to buy) a penny stock.

If the trading volume is high, then start with some basic math.

Take the trading volume and multiple that by the current price of the stock. This will tell you the “dollar volume” or how many dollars in total this stock traded today. Frequently, I have seen stocks that trade for under a penny and have millions of shares trading on a given day. After doing basic multiplication, the dollar volume can about to $1000 to $30,000. In some stock you can buy all the shares for $5000 or less, but would you want to. No. Why? Because if the company had real value it would not be $5,000 right? Why does for example, Apple and Google sell for a high price and has a market cap (present market value of the company’s stock price) in the billions? Because their company has serious value.

Penny stock investing (I call it super speculation to gambling) has nothing to do with fundamental (earrings potential, etc.,) or technical analysis (stock price chart movements), market forces (legitimate news, etc.), it’s all for the purpose to defraud unsuspecting penny stock investors.

Once the promote and or insiders dump their stock on that information hype, there is no one left to prop up the stock; they don’t need to seek new investors; thus the stock crashes, and volume dries up.

Also, keep in mind that when trading penny stocks, you may be the only buyer. The spread, (the difference between the buy (ask price) and sell (bid price) may be so wide, you can drive a Mack truck through it.

Example: .05 Bid x .10 Ask.

To buy this you are likely to pay 10 cents; to sell it you might get 5 cents. Thus there is a 100% market up the buyer is paying, and if you want to sell it you will get ½ your money back if you are lucky unless a new investors is enticed to bid up the stock. There is a lot more detail I can get into, but for the purpose of this article, the point is that spreads in these stocks are huge.

Now compare this with a major corporation on NYSE or NASDAQ the spreads are often down to 1 cent. (1999 NYSE Conference paper on changing trading from fractions to decimals: PDF 13 pps)

The key is to avoid penny stocks to begin with.
If you want to GAMBLE in these low prices stocks, look at a 3+ year balance sheet, look at their actual sales revenues, look at their net assets over debt, and see if there are more than one shareholder and who do not all share the same or similar names. Now, there are many small companies who have legit businesses, and not all penny stocks are scams waiting to rip you off. These companies will have records, and financials filed with the SEC and will be available on-line. Their financials should be AUDITED by a known independent accounting firm. Avoid reading the “potential” of the company or how much they THINK they could make, especially if it sounds too good to be true.

Companies who do not fit this model having basic financials are likely shell corporations who do nothing but serve as a trading vehicle for insiders (schemers) to make a quick buck off naive penny stock investors.

What investors need to know is this:
If the company has a REAL product or service that massive people need, and a viable future, there would be $10’s to $100’s of millions in venture capital begging to develop the business. There would also be Wall Street investment banks also looking to do the same.

For those who still want to speculate in these high risk stocks, make sure you do your homework before investing. Keep in mind that “newsletters,” emails, etc., are considered to be “advertisements” and are not deemed as legitimate financial data. Finally, make sure you can afford to lose 100% of what you put into the low priced stock.


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