In a large number of cases, penny stocks [defined as stocks that trade below the price five dollars] are likely to be manipulated by shady operators who use hype and false information to drive up share prices and then unload their stocks on an unsuspecting public. Many investors do not really take advantage because they are fixated by the prospect of getting in on the ground floor of a promising new business and dream of the returns that will accrue if they find the next Microsoft. It is true that all big companies start small but it is equally true that stocks like Microsoft come along once in a blue moon. Pursuing this strategy is far more likely to lose you money.
Once you expand your outlook, you would begin to understand that you can consistently make money by doing exactly the opposite which is to short a stock which you think is the target of a pump and dump. Just as the unscrupulous promoters are looking to make money on the way up, you can look, quite legitimately, at making money when the price is on its way down. All you need is a margin account with your broker and the ability to borrow stock from your broker because you are selling shares that you do not possess.
One strategy that will enable you to spot the pump and dump and to determine your entry point and your entry price is to look at sudden and sharp spikes in the share price. If a stock gains say 50 percent in the last few minutes of trading, it is a sign that a pump is in progress. You can short the stock immediately the market opens on the next trading day. Don’t panic if you find that the opening price is already 10 percent down on the closing price of the previous day. The price has a long way to go down.
Another strategy that is extensively used in trading large cap stocks works reasonably well with penny stocks and again depends on intraday price movements. This is a gapping strategy where you look for stocks that have gapped up by say 10 percent over the opening price during the course of the trading day and then falling below the opening price on the same day. When this happens and the price declines towards the closing of the previous day, it is known as gap fading and could provide the signal for you to enter the stock. You should however remember that gapping up that on the basis of news that is highly favorable to the company and if this is genuine news, don’t bother to short the stock. You should act only when there is no substantial basis for the price to gap up. As a general rule, a spike in the price of a penny stock is the sign of a pump only when the price hike is based on hype and buzz and you cannot find any good reason for the increase in price. After all, if you sell short on a stock where you cannot confirm the pump, you are unlikely to make any money on the subsequent dump.