Monday, March 9, 2009

Penny Stocks and Associated Frauds

Guest Author : Shabu Thachat

Penny Stocks are scrip’s which are valued less than 5 in most of the currencies and some of them are even less than 1. So, we are talking about the Penny scrip’s in this article.

It is bit confusing at times, as lot of good stocks come down to 5 and below. We cannot label all of these shares (below Rs.5/-) as actual Penny stocks and even if we treat them as penny stocks, some of them have good growth potentials and may be the future multi-baggers. Investing in such stocks might create great wealth in long term. I will publish another post about few good penny stocks later in this blog. But why do stocks are valued less than 5 rupees or dollars?

There are several reasons behind a share price getting cheaper and I will list out some of them below.

1. Inferior management
2. Negative earnings
3. High scale debts
4. Global trends and trend changes in products
5. Untimely listing
6. Better competitor’s entry
7. Negative rumors or certain sentiments on issues related to the company
8. Not being the darling of media

Basically these shares don’t have enough buyers or demand to get a higher valuation.

The advantage of Penny stocks is its affordability and everyone can buy it because of its low value. For example, you can purchase 10000 shares just for Rs. 5000/- at 50 paisa per share. If this share reaches even at Rs 1/-, you will get 100% return and this is the beauty of these stocks and if you have enough patience, some of them can change your life forever.

The volumes of such shares also exceptionally low compared to others as well as the number of trades. Some brokers and group of individuals are specialized in the trade of penny stocks. My request to the new and innocent investors is, to stay away from intraday trading of such stocks. It’s hazardous, until you are not fully aware of the penny stock stunts behind the screen.

With a low volume stock, it is easy to manipulate the share price. For Example, if you have Rs.1 stock trading 50,000 shares a day and someone comes to buy 25000 shares then it will have considerable effect on the share price for sure. It can happen to any stock but the probability is more in penny stocks as its value is so cheap that you can trade in a candy to a stock. People might even trade due to its teasing numbers. For example some people are happy to have 10000 shares in their account rather than 10 State Bank of India shares for the same value of investment.

Boiler Room Tactics:

Penny stocks are also the favorite trading tools of some unethical people who work in Boiler Rooms because of its low volume. Boiler Room is a practice where unethical brokers / sales people convince potential investors (Rather scapegoats) to buy an insignificant stock. Obviously, the price will go up because of increased demand and the brokers/insiders in the boiler room sell their shares for an ample gain. By the time you want to sell, it is often too late. You will lose the major part or all of your investment.

A considerable percentage of price increase or Penny stock in a Top Gainer’s list in a particular trading session, may guide some innocent investors to wrong buying decisions. Anticipation of further price hike leads them to purchase such stocks which finally land them in a heavy loss. Online intraday traders are the major victims of such fraudulent activities because they trade on the basis of tips or baseless information.

If an unknown person/firm advises you through Phone/SMS/Mail to buy a penny stock showing the percentage growth on a particular day or so, please be alert. They are experts to trap you by their lexis like “This share price is very much low….. the company is going to merge with so and so…….the company have got an order from so and so…….” or anything which tries to establish that the stock is hot. Please be very careful.

Thousands of people fall in such scams everyday. The boiler room brokers/insiders are skilled enough to make you feel that you are going to miss out a life time opportunity if you don’t buy the recommended scrip at that particular time. If you jump in then it is difficult get out without severe burns.

Pump and Dump:

One of the usual penny stock frauds is the Pump and Dump. A tiny group of speculators will gather some large number of shares of a penny stock. Once their positions are in place, they will release positive financial news, which so unexpected and can drastically affect people's insight of the particular stock. The intention is to grab short term investors to involve trading illogically. The news would be probably false, but before it is discovered, the price of the scrip often shoots and the original insiders might exit with big profits.

Poop and Scoop:

The other variant of Pump and Dump is a penny stock deceit called the Poop and Scoop. Here the insiders spread highly unconstructive bogus rumors about a company in order to bring the price down. These people buy as the scrip sink and wait for a recovery in price once the rumor is dissolved.

The other side of Poop and Scoop is, these people sell their holdings before releasing such news and after the following turn down, they make big purchases and keep for a profitable sell after the suspension of rumors.

Front Running:

Another penny scam is known as Front Running. Here, the news is factual and the insiders/brokers are well aware of what is going to happen. They take good positions before the news becoming public. And the rest you know. It is also illegal.

Circular Trading:

The another term Circular Trading is, when a stock has been laying idle for a long time, insiders trying to increase the importance of that particular scrip. They use multiple accounts and will trade the same shares back and forth between their own accounts to create the symptom of motion in that particular scrip. The artificial hike in prices and falsified number of trades may attract some investors. Once a third party placed an order, it will be executed and the insiders will exit with good profits.

I am not against investments in penny stocks. But Trading, especially intraday is harmful without proper intelligence. Some of the penny stocks are in this category because of the global melt down. Do your home work before investing in any of the Penny stocks especially on their fundamentals. A lot of hidden gems are there which will come out and show their growth after this ill-fated period.

Shabu Thachat, Calicut, Kerala.


BULLS March 10, 2009 at 12:47 PM  

Nice Article indeed. Unique in its own kind yet quite technical & logical views.


Shabu's March 10, 2009 at 11:11 PM  

Thank you Bulls for the encouraging comment. Thanking to MR Kumaran also.

Mahesh March 10, 2009 at 11:38 PM  

Excellent Article. One thing i knew about Bellary steel is that Karvy brokers made huge speculation about it which pumped up from Rs 3/- to Rs 12/- [not aware of no of sessions it took to reach 12].

This article brought brighter light to more about penny stocks.

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This is really one of the best article I have come across

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AllenMass May 6, 2010 at 5:25 AM  

Thank you Bulls for the encouraging comment.

Penny Stocks May 6, 2010 at 5:25 AM  

Write good content about penny stocks.

MathewBracken June 22, 2010 at 8:12 AM  

Great article indeed. I read & appreciate.

Anonymous,  June 22, 2010 at 12:32 PM  

very good article...tells you why short term or day trading is not for part-time "investors".

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