Penny Stocks have long been the attraction of a lot of investors because of the tremendous returns that these stocks can generate in a short period of time. The reason that some of these stocks are able to generate such high returns which goes as high as five or even ten times the amount invested is the price and the volume of these stocks are low.
Because the volumes are low in such stocks when interest is generated in such stocks and people start investing the sudden spurt in volume leads to a large increase in price of such stocks.
And that is the danger that exists while investing in these stocks. Because one can raise the prices many folds just by investing a few lakhs. Many a time these stocks are the target of Promoter manipulation.
The modus operandi is quite simple. A few promoters group together and generate artificial interest in a particular penny stock. Suppose there are two promoters who hold majority of the stock in their company where the volumes in the markets are low. Now one promoter will start selling his stock in the open market and the other promoter will keep on buying this stock at progressively higher prices. Since the volume is low the promoters are easily able to jack the prices by doing this. At the same time they also engage in spreading rumors about the company and create interest among the ordinary investors. They are easily able to prop up the prices from a low of say Rs.5 to a high of Rs.20.
You can think of the two promoters as husband and wife and think that the husband has sold off all his shares to the wife and the wife has paid for the stocks. The net effect remains the same as the stocks of the couple remain with them and so does the money. Although in the real world the trade is more complex this analogy helps us to understand what exactly is going on in this transaction.
Now at the same time there is “real” demand for the stocks of the company in the market by investors other than the wife and it is at this time that the “wife” starts selling off chunks of her shares to the public at these propped up higher prices. Now because there is a genuine demand for those stocks in the market the prices do not fall as suddenly as they went up and this gives a good opportunity for the wife to get out of the stocks at a higher price than what they had originally had the shares for.
This is a neat way promoters have come up of making money in the penny stocks but at the same time other investors who are not well informed about the stock market become victims and lose their money in the deal.