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Buying Penny Stocks - The Risks of Buying Penny Stocks

Updated on March 25, 2013

If you're hoping to start buying penny stocks, you need to understand that penny stock fraud is unfortunately a common phenomenon, especially on the Internet . This form of securities fraud involves the manipulation of stock trading through contrived data. A number of common schemes exist despite how the perpetrators blatantly violate securities laws.

Most commonly, buying penny stock fraud occurs when one party deceptively presents data on commodity and stock markets to prospective buyers. The base purpose is to compel investors to spend their money after being persuaded by this deceptive data.

Such fraud has been common for quite some time, but it is now becoming more visible and arguably more frequent with the propagation of such schemes on the Web. However, the basic schemes themselves remain, for the most part, the same as their offline precursors.

Buying penny stocks can be an exciting and lucrative endeavor, but many wade into it naively. I hope to help you identify and avoid such fraudulent activities and invest in a safe and responsible manner.

Buying Penny Stocks Requires Skepticism and Caution
Buying Penny Stocks Requires Skepticism and Caution

Buying Penny Stocks Deception Through Off Shore Investing

This was once a relatively uncommon security fraud scheme, but with the growth and accessibility of the Internet, previous barriers to its exploitation have all but disappeared.

Investors operating in Canada and the United States are the most common targets of this scheme.  Be very vigilant and responsible when considering any kind of investment based in a foreign nation.  If you fall into the trap of a foreign investment scheme, you may find it very difficult for law enforcement officials to assist you in identifying and prosecuting the foreign culprits.  Buying penny stocks isn't worth this foreign risk.

Despite Media Attention, Penny Stock Ponzi Schemes Persist

Unless you've been living under a rock, you have probably heard of Bernie Madoff's horrible abuse of innocent investors' money through the most ambitious Ponzi scheme ever. Named for Charles Ponzi for his mischief in the first half of the twentieth century, a Ponzi scheme is essentially a pyramid scheme in which a broker or financial adviser leverages the money given to him or her by fresh investors to contrive profits for his or her existing investors.

It is amazing that these schemes persist as the scheme always collapses eventually when the new investors accumulate into a large roster of existing investors. Basically, it is inevitable for the debt owed to the growing roster of existing investors to overwhelm any money brought in by new investors. These fraudsters, who when it comes to buying penny stocks can and will hide behind so-called penny stock newsletters, often disappear online before you understand what's happening.

Unfortunately, this exact system can be applied to trading penny stocks, so be sure to research your broker or financial adviser helping you participate in penny stock trading before you trust him with your trades.

Prime Bank Securities Fraud

As soon as you read or hear the term "prime bank" used in a pitch to appeal to you in any way, turn around and head the opposite direction.   Basically, it is a term used by criminals to portray their manipulaptive techniques as somehow more legitimate.  Essentially, a fraudster will claim to use your investment for trading financial instruments for prime banks.

A prime bank is one of the world's top fifty banks, and their financial instruments include International Monetary Funds, Federal Reserve notes and world paper.  What usually happens is that the instruments described don't actually exist and the victims flat out lose money.

If you intend to buy penny stocks, you should steer clear of any deal involving prime banks or financial instruments.

Be Wary of the Pump and Dump When Buying Penny Stocks

The pump and dump scheme is another scheme which has become more common with the proliferation of the Internet. This particular scheme is incredibly common among people buying penny stocks, so pay close attention here.

Basically, a group of savvy investors persuasively hype a low value, high volatility stock to a large number of targeted investors. This hype causes a rush of buys which in turn drives the vulnerable stock briefly upwards. As the stock rises, the small group who initiated the hype then sells off the stock before the stock returns to its normal value.

You'll often find this illegal technique executed through email newsletters, and penny stock newsletters have become strangely widespread in recent years. I suppose as more people explore the possibility of buying penny stocks, more sharks appear to exploit the eager new investors too impatient to do their due diligence.

The pump and dump scheme is most often used with penny stocks (also referred to as micro cap stocks or small cap stocks). These stock are traded on the OTCBB (Over-the-Counter Bulletin Board) or with Pink Sheets. This is because smaller companies on these stock exchanges are lesser known and don't have to fulfill the same public standards as stocks on the major exchanges. Thus it is much easier to temporarily manipulate public data on them.

The Billion Dollar Penny Stock Fraud Industry

People are too impatient and too eager to get rich quick. Just as people continually ask does p90x work instead of getting their butts off the couch and finding out for themselves, people are constantly finding themselves suckers to fraudsters when it comes to investing.

Microcap stocks are stock with market capitalization below $250 million. Microcap fraud is more of a blanket term for all the schemes I have described so far but as applied to microcap stocks or penny stocks. Penny stocks are generally microcap stocks that trade for under $5 per share.

Despite being well-known and very illegal, microcap fraud has been formally estimated to involve billions of dollars every fiscal year. So as you wade into the waters to buy penny stocks, I urge you to exercise caution and skepticism.

Before You Start Buying Penny Stocks...

As begin buying penny stocks, how can you avoid all these clever attempts to pray on the naive and the hopeful? Be very skeptical of bulletin board trading; you often do not have verified information on the posting identity. Be wary of any Internet newsletters, especially newsletters which come with any degree of hype whatsoever.

Such penny stock trading newsletters are almost always composed for paid promotions. And remember the golden rule: if something sounds to good to be true, it probably isn't. I know that sounds so obvious and mundane, but if you really audit your trading activity with this understanding, you'll steer clear of many disasters.

And last but certainly not least, should you become involved in or suspect a scam or scheme of some kind, do us all a favor and contact the Securities and Exchange Commission (SEC).

Investment scams on the Web really are not new; they are just different manifestations of classic schemes which have persisted for decades. But these scams persist because so many people are so full of desperate hope that they'll do anything to get an edge. And unfortunately, because of their volatility, penny stocks are the most susceptible to almost all of these skins.

So before you start buying penny stocks, be reasonable and be vigilant and always do your due diligence.

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