Beware of the 'pump-and-dump' game in penny stocks

Investors often come across a penny stock tip-off that promises returns that are too good to be true. With the benchmark indices scaling new highs, can the tricksters be far behind? Investors who are new to the stock market, in particular, need to guard against such dirty tricks at play. “If something is too good to be true, it often is. It’s better to stick to the basics and always be cautious, brokerage firm Zerodha has cautioned investors in a tweet.

It further stresses the age-old wisdom, “Trust but verify.”

Zerodha also shared the blog written by its CEO Nithin Kamath about horror stories of many new investors losing money to such too-good-to-be-true deals.

For the benefit of retail investors, Kamath explains the ways to identify such frauds. The blog also reveals how Zerodha has been helping investors avoid losing money to swindlers.

How penny stock scams work

Throwing light on how penny stock scams work to trap investors in a ‘pump-and-dump scheme’, Kamath writes that people holding majority shares of a company artificially move up the price of the penny stock by incrementally placing small buy orders at inflated rates.

As soon as the price of these penny stocks starts rising, “a buzz is created through bulk SMSes, social media and various fora pushing new investors into buying these stocks. The prices start rising further”.

However, soon the operators (those controlling majority shares) begin selling the stock, abruptly the prices start falling and all the buzz around the penny stocks stops, giving the new investors no chance to sell their shares at even a break-even point.

What investors can do?

Sharing tips that would help guard against such fraudulent activities, Kamath advises investors not to share login credentials with anyone, allowing them to trade on your behalf.

New investors should stay away from such trades if they don’t thoroughly understand them since such trades are full of risks.

Kamath says one should invest only amounts that one is prepared to lose. All in all, he advised new investors to stay away from penny stocks.

The Zerodha CEO also explained the checks the brokerage has put in place to help investors avoid falling prey to frauds. “We now have an illiquid option check on the order screen to help you out even if you are being deceived by someone. Orders will get rejected on options contracts which we believe can be used for executing non-genuine trades to create a loss in your account.”

It also advises its investors to not trust buzz created through social media or SMSes in the form of tips on penny stocks which promise quick returns.