Ways Penny Stocks Take Advantage of Investors

| April 12, 2012 | 0 Comments

Penny stocks are a popular topic among amateur investors. Often considered to be an effective way to make a large amount of money in a small amount of time, penny stocks can be a double edged sword. People are always talking about the best penny stock to buy or the hottest penny stock, when this changes from day to day. Penny stocks are not typically something that investors will buy and hold, as money is more effectively made from their volatility than long term growth.

Penny stocks are often used by less-than-ethical investors to make quick money at the expense of other investors who lose huge amounts of cash.

The first is pump-and-dump schemes. These schemes take advantage of the fact that penny stocks are extremely volatile, illiquid and trade on small markets. In fact, these three attributes have more in common than their shared association with penny stocks; they also somewhat influence each other. That is, for example, the illiquidity of penny stocks is often partly caused by the fact that they trade on a small market.

Basically, the pump-and-dump strategy involves pumping up the price of a stock, riding it up as the price artificially inflates, and then selling off before it crashes. With penny stocks, the price can be manipulated because the volume of stocks is so small. If one person buys up a large percentage of the shares, it creates the illusion of increased demand which sends price up. The crash happens both because people realize that the stock was grossly overpriced and because the large sell off creates a sudden large supply.

This strategy can be used in reverse as well, by shorting stocks en masse in conjunction with a negative press release to drive prices down below the real value of a given stock. The investor then buys to cover when the stock is about to hit bottom.

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Category: Investing in Penny Stocks

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