Penny stocks come with high risks and the potential for extraordinary returns, so investing in them requires care and caution. Penny stock companies are often headed for bankruptcy or are highly overleveraged, because of that investing in penny stocks is risky. There are two ways to make money with penny stocks, but they’re both high risk. Below is a breakdown on the risk and rewards of penny stocks.

The Lowdown on Penny Stocks

Penny stocks can be defined in many different ways. Most people logically assume that penny stocks refer to stocks trading for less than $1. However, the SEC defines penny stocks as stocks trading for less than $5. Generally, penny stocks trade on the Pink Sheets or FINRA’s OTC Bulletin Board (OTCBB). Both exchanges should be approached with extreme caution, but even more so the Pink Sheets since these companies aren’t required to file with the Securities and Exchange Commission (SEC). And don’t get your hopes up with stocks trading on the OTCBB. It’s still difficult to find information to formulate a logical conclusion on whether or not the company is likely to survive, let alone thrive.

Whether the penny stock trades on Pink Sheets or the OTCBB, it will be challenging to find credible information. Keep in mind that there are no minimum standards for a company to remain on the Pink Sheets or the OTCBB.

Penny stock scammers deceive by luring inexperienced investors into investing in cheap and worthless stock and taking their money. Be careful not to get caught up in one of these common penny stock scams. Below, are examples of other common penny stock scams you should avoid.

Pump-and-Dump Schemes

This fraud happens all the time. Promoters drum up interest in a scarcely known or unknown stock. Inexperienced investors buy up the shares, pumping the price. Once the stock has reached a certain inflated price, the bad guys sell or dump, the stock at a huge profit. In turn, investors are left high and dry. These pump-and-dump schemes are often distributed through free penny stock newsletters, where the publisher is paid to list these unpromising and hyped-up stocks. If you get one of these newsletters, read the fine print on its website. You may notice that the companies or promoters are paying the author of the newsletter to feature them.

Short-and-Distort

This is the opposite of the pump-and-dump. Scammers use short-sell to make a profit. Shorting works when the investor borrows shares and immediately sells them in the open market at a high price, hoping the company stock falls so he can later scoop up sold shares at a lower price. He then returns these shares to the lender and nets a profit. Penny stock scammers short-sell a stock and make sure the stock falls by spreading false and damaging rumors about the company. Investors hold a losing stock, while short-sellers make money through their short-selling trick.

Reverse Merger

Sometimes a private company merges itself with a public company, so it can become publicly traded without the hassle and expense of going through more traditional methods. This makes it easy for the private company to falsify its earnings and inflate its stock prices. While some reverse mergers are legit, you can catch a reverse merger by reviewing the business’ history and detecting spotty activity in its merger.

Mining Scams

Gold, diamonds, and oil have always been alluring. One of the most famous mining scams was Bre-X, in the mid-1990s, when founder David Walsh falsely claimed his company found a massive gold mine in Burma. Speculation soared fast until the company’s valuation, all in penny stocks, was worth $4.4 billion by 1997. When the company collapsed, most investors lost everything.

The Guru Scam

Guru adds are commonplace, and sadly people fall for them easily. These false ads usually show you how the ‘expert’ became rich through a special ‘secret’ and acquired materialistic success, such as glitzy cars, lakefront houses, and boats. The ‘expert’ promises to share his penny stock trading secrets with you for a ‘one-time’ low sum. If someone dubs himself a guru or promises to make you rich, trash that email or envelope. There is no “one-size-fits-all” path to riches, and certainly not in the stock market. In a similar way, avoid those schemes that promise you unlimited success from a once-in-a-lifetime product or invention that claims to be the next Thomas Edison invention.

“No Net Sales” Scams

This is when scammers sell shares of a company, stipulating that investors cannot sell the shares for a certain amount of time. The investors buy because they are fooled into thinking there is huge and continuing demand for this stock. By the time the U.S. Securities and Exchange Commission (SEC) shutters these companies, investors are left with nothing.

Offshore Scams

The U.S. Securities and Exchange Commission says that companies who operate outside the United States do not need to register their…