Penny stocks are a great way for beginning investors to practice trading without risking more than a few dollars—and, if you're lucky, some of the investments might even be profitable in the long run.
Unfortunately, penny stocks are also a perfect vehicle for "pump and dump" investment scams, a type of stock fraud that preys on the unwary.
It works like this: An individual or group of individuals find a penny stock and buy a lot of shares at rock bottom prices. Then, using the internet and other media outlets, they hype the company as the next "big thing" in the market. Tactics range from unsolicited emails to blog posts and news stories praising the company and predicting its success. Investors who research the company keep finding positive information everywhere they look, so they become convinced and buy in. The increased buzz and trading activity starts to artificially inflate the stock price very rapidly, making the predictions seem true. More investors buy in at increasingly inflated prices. Then, as interest (and price) is at its peak, the original investors dump their shares, selling at the inflated market price. They make a huge profit, but everyone else loses most of their investment as the stock falls back down to penny value again.
Scams like these don't just catch brand-new investors. They're increasingly sophisticated and can end up involving brokers and traders that have been around for a long time. Sometimes the brokers begin to realize what is happening but are already financially bound up in the scam themselves, so they continue hyping the stock to clients and hope for the best.
For example, eight men were recently sentenced in Cleveland courtroom for a pump and dump scam involving penny stocks that netted one of them $39 million dollars. The other seven were believed to be pawns in the ringleader's scheme themselves, but continued to encourage clients to buy the stock even when they knew it was being artificially inflated.
This suggests that they may have been hoping to get out of the mess without getting caught or they'd become so financially entangled they were acting out of desperation.
If you find yourself in the middle of a stock scheme that's really a scam, don't wait until federal investigators come around to find legal help. An attorney can discuss your legal options before everything falls apart.
Source: Investopedia, "How does a pump and dump scam work?," Investopedia Staff, accessed Feb. 16, 2017