Penny stock investing can be extremely lucrative, but the market is also filled with penny stock scams.
And separating the penny stock scams from the legitimate businesses is the first and most important step in penny stock investing.
The most common penny stock scams are "pump and dumps." This happens when someone promotes a stock that he or she owns in order to artificially raise the stock's price. Then they cash out their shares for a profit at the high price. Frequently, the stock will then crash.
There's also the "dump-and-dilute" scheme, in which companies continue to issue shares only to take investors' money.
Sometimes, brokers will buy shares from stock promotors for pennies and then sell them to clients at a much higher price. The promotor and broker will then split the profit. This is known as a "chop stock scam."
These types of scams can all leave unwitting investors penniless.
Take the case of CYNK Technology Corp. (OTCMKTS: CYNK), for example. From mid-June to mid-July 2014, shares climbed more than 23,000%. But the company was a scam, and the U.S. Securities and Exchange Commission halted trading in mid-July. When trading resumed, shares crashed from $13.90 to $0.10 in less than two months.
That's why we've created a five-step process to help you determine penny stock scams from the legitimate investments. Don't buy a single penny stock until you've read this list...
Avoiding Penny Stock Scams Tip No. 1: Stick to Major Indexes
One of the fastest ways to avoid penny stock scams is by sticking to major indices like the New York Stock Exchange or Nasdaq. However, that will also cut down on your penny stock options.
Many penny stocks trade on the Over-The-Counter Bulletin Board (OTCBB) or the Pink Sheets. The downside, however, is that the OTC markets and Pink Sheets do not require the same reporting standards for financial information as the NYSE or Nasdaq. Therefore, some scam companies do not fully report financial information.
If you want to try trading Pink Sheet stocks, use their classification system. They have several classifications for stocks, including the "PremierOX" and "PrimeOX" categories.
PremierOX companies sell for at least $1 per share, have at least 100 shareholders with a minimum of 100 shares each, and meet the requirements of the major exchanges. PrimeOX companies have no minimum share price but have at least 50 shareholders with 100 shares minimum.
Sticking to those two categories will help weed out the penny stock scams on the Pink Sheets.
Continue reading for four more tips for avoiding penny stock scams...
Avoiding Penny Stock Scams Tip No. 2: Continue Researching
You should be researching any investment, but it's especially critical when picking out penny stock scams.
The first place to go is the company's index. Check out the NYSE or Nasdaq websites for stock information, research reports, and company profiles. Always check the company's own website as well.
Don't hesitate to contact the company directly and request any information available. Almost all will offer financial and product information to investors. If a company does not provide this information, there is probably a reason why. Be guarded.
If the company is located outside of the United States, research the political, economic, and social situations of the country. Don't forget to review the business laws of the country. Frequently, the company will provide this information for investors.
Avoiding Penny Stock Scams Tip No. 3: Find Buyout Targets
Money Morning Defense & Tech Specialist Michael A. Robinson also urges investors to look for companies that could be buyout targets.
"Many small companies are prime buyout candidates," Robinson said. "Typically these companies have a market niche, a technology, a promising drug, or a product (even patents) that a larger competitor desires. And many times, the purchase price is much higher than where the penny stock currently trades. This gives those shareholders an instant gain."
Finding a company that's prime for purchase could bring big gains to investors in a short period of time. Any takeover announcement will serve as a huge catalyst for the penny stock.
Follow M&A trends to see which industries are the hottest for takeovers.
Avoiding Penny Stock Scams Tip No. 4: Find the Right Products
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Another winning strategy is finding companies that are about to bring major products to market. Products can also include new medications.
If a product or medication takes off, the company's stock will do the same.
"Many penny stock companies, especially health-related biotechs or innovative technology companies, spend years researching and developing their products," Robinson said. "This may include lengthy and rigorous testing. Pharmaceutical biotech products can spend years in trials and tests."
Find stocks that are toward the end of the testing process. This means their products have a better chance of reaching the market.
Avoiding Penny Stock Scams Tip No. 5: Invest the Proper Amount
Maintain perspective when investing in penny stocks.
Only allocate a small portion of your portfolio to the good penny stocks you've identified. Betting on too many long shots is risky and not a winning strategy. Betting the 50-1 longshot every time may result in a winner every once in a while, but it's a foolhardy strategy.
Don't view penny stocks as your lottery ticket, and assess your penny stock investments like you would any other stock. Getting caught up in "what-ifs" instead of calculated research could doom your portfolio.
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Profit Alert: Now that we've detailed the five steps for avoiding penny stock scams, it's time to start looking for winners. Here are the top three penny stocks we're recommending now, and why they all have triple-digit potential...