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The Skinny on Penny Stocks

The term "penny stock" is one that can either strike fear and skepticism into the hearts of investors, or alternatively, suggest the possibility of great opportunity to make many times an initial investment in a relatively short period of time in a little-known company.

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"Penny stocks are a fascinating, shadowy underground world, consisting of micro-sized, but legitimate, businesses looking to raise equity capital. (They can include) legitimate but speculative entities, out of favor stocks, companies entering or emerging from bankruptcy, dormant corporate shells waiting for a buyer, criminals looking to steal people's money, and everything in between," says Arthur Patten, president of Symmetry Capital LLC, in Jenkintown, Pa.

Complicating matters for investors is the fact that recent market activity has pushed many companies' stock prices below $1 a share and has blurred the lines between penny stocks and those that simply trade at a relatively low price.

"Anytime there's volatility, there is always going to be a way to get rich quick, and con artists will pray upon that," says John Stark, chief of the Office of Internet Enforcement at the Securities and Exchange Commission.

With market conditions apparently ripe for penny stock trading and scamming, Bankrate offers this primer on the class of securities known as penny stocks.

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The SEC defines a "penny stock" as low-priced shares of small companies that typically trade infrequently, generally over the counter and not on a stock exchange. It is sometimes difficult to find price quotes on these companies and to obtain accurate pricing. The SEC warns that investors who invest in such securities may be at risk of losing their entire investment.

"You should, in general, take the same approach to choosing a stock that you would take in choosing a heart surgeon. Talk only to people you really trust. When you're talking about buying a stock, you're talking about your future," says Stark.

While that's true of nearly any type of investment, the risks in penny stocks may be even greater for several reasons.

Penny stocks are sometimes recommended and sold as a result of fraudulent activity to induce investors to take part in what amounts to a "pump and dump" scheme. Those involve the dissemination of overly optimistic claims about a particular company's prospects, via e-mail and press releases, or on message boards to "pump" up the price of the stock, the SEC says. DESK: http://www.sec.gov/answers/pumpdump.htm

Symmetry Capital's Patten is especially skeptical of some "newsletters" pushing penny stocks. "One of the earliest clues in these and some other types of scams is the promise of staggering returns for only a small subscription fee," Patten says. "In those cases, the best you can hope for is that the author and publisher only make money from subscription fees.

"The worst case explanation is that they stand to benefit substantially from any interest in the stock, however transient. In other words, you're going to end up putting more than a subscription fee in their pockets!" Patten says.

Since many such companies typically trade infrequently, a small increase in purchase activity may cause the stock price to rise, sometimes quite precipitously. At this point, the sources of the original positive information sell, or "dump" their shares, often at a huge profit. Victims of this scam are lucky to recoup any significant portion of their original investment.

"While professional institutional investors should be better able to defend themselves against scammers, penny stock scammers deliberately target people who are less experienced and knowledgeable," says Patten.

Next: Buyer Beware....