Unscrupulous penny stock promoters use pump-and-dump sales tactics to move money from investor bank accounts into their own pockets. The very low level of regulation and oversight in the over-the-counter stock market allows penny stock promoters to make their money and disappear long before any government regulators can try to stop the practice. When you understand how stock pumpers work, you can see a pump and dump coming before you commit and lose your money.
Penny Stocks Trading OTC
Over-the-counter stock trading offers a trading venue for companies that cannot qualify to list on the stock exchanges. Investment firms acting as independent traders -- market makers -- control the buying and selling of OTC stocks. Penny stocks are shares of very small companies with low share prices that trade OTC. Investors can get excited about buying shares for less than a dollar that they hope will rapidly increase to several dollars per share or more.
Great News Equals Chance to Get Rich
The penny stock pump starts out with hot news spread on Internet investing sites or by salesmen using the phone -- news that a small company will soon, in the next few days, announce a new product or contract that will transform the company into a big player in its industry. Before the "hot" news about the penny stock company is released, a large portion, if not all, of the shares will be owned by company insiders or the investment firm that will start heavily promoting and selling the stock. During the pump phase, these share owners plan to unload their shares at great profit to themselves.
Get in Now or Miss the Opportunity
One feature of the pump and dump -- and also a signal that investors are in for a ride they won't like -- will be heavy sales pressure to buy shares right away to avoid missing an opportunity. The aggressive sales tactics will cause shares to sell, and the stock price will start to rise, possibly dramatically. As shares are rising, the insiders are selling their shares to the excited investors. When the selling pressure stops, it will be hard to find buyers for the shares and the share price will drop as fast as it rose.
Recognizing the Warning Signs
The biggest warning sign of a penny stock pump and dump is the sales pressure. "Investors" may flood online investment forums with promotions for the stock, but these people are insiders working to unload their shares. Another tactic is to use a "wrong number" voice mail message promoting the stock. To avoid getting caught in a pump, ask for literature on the company to be sent by mail. If the company is legitimate, you will receive some information to help with your investment decision. If you receive nothing by mail, you know the investment opportunity behind the promotion is nonexistent.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.