Investing in so-called penny stocks is certainly attractive. If you buy a stock for 10 cents, it only needs to increase by a mere dime to double your money, right?
But when it comes to investing, things are usually not straightforward. If anything, penny stocks can be a great way to lose a good amount of money.
Just look at the 2011 crackdown by the Securities and Exchange Commission in which it suspended trading in 17 penny stocks because of concerns about the accuracy of the financial disclosures.
As should be no surprise, all the companies were traded on the over-the-counter (OTC) market. The two main platforms include the OTC Bulletin Board and the Pink Sheets. Keep in mind that the OTC market is not like a traditional exchange, such as the NYSE or the Nasdaq. Instead, it has fewer requirements and standards. As a result, it is easier for stock promoters to pull off frauds.
Another problem is that the liquidity in the OTC market is usually minimal — that is, if you have to sell your shares in a pinch, you could end up taking a big discount on the price. In some cases, it can be steep — think 5% to 10%.
And, when there is high volume, it’s typically for short bursts. This often occurs because of big promotions from an investor relations firm, known as a “pump and dump.”
Finally, the companies on the OTC often have little cash or revenue. Yet they still will claim that their potential is huge. To this end, many will latch onto one of the latest hot trends, such as social networking.
Legitimate businesses are traded on the OTC market. But you need to do some extensive research — and understand the business. If you’re not willing to put in the legwork, it’s a much better idea to focus on stocks on the main exchanges.
Tom Taulli’s latest book is “All About Short Selling” and he has an upcoming book called “All About Commodities.” You can find him at Twitter account @ttaulli. He does not own a position in any of the stocks named here.