Every investor dreams of finding the next stock that could deliver 10x, 20x, or even 100x returns.

And penny stocks can be especially tempting. After all, when a company is worth just a few million dollars, even a relatively small business breakthrough could send its stock soaring.

But these stocks are often cheap for a reason… and that’s why so many investors lose money on them.

The challenge is figuring out whether you’re looking at a legitimate opportunity—or a company that’s simply selling investors an exciting story.

Here are five red flags every investor should watch for before investing in one of these speculative companies.

1. The stock barely trades

One major risk with penny stocks is liquidity.

Simply put, liquidity measures how easily you can buy or sell a stock without significantly affecting its price.

When a stock trades millions of shares every day, there’s generally a large pool of buyers and sellers.

But with a thinly traded penny stock, you might struggle to find someone willing to buy your shares at the price you want.

Imagine buying $10,000 worth of stock in a tiny company.

A few weeks later, some positive news sends the share price up 50%. On paper, you’ve made $5,000.

But when you try to sell, there aren’t enough buyers at the quoted price. You may have to accept substantially less than you expected just to exit the position.

And if bad news hits, that same lack of liquidity can make the losses even worse.

That’s why it’s important to look beyond a company’s share price. Check its market cap, average daily dollar volume, and bid-ask spread—the gap between what buyers will pay and what sellers will accept.

The lesson: Before buying a penny stock, make sure you’ll have a realistic way to sell it.

2. Management keeps chasing the next big trend

Another warning sign is a company that repeatedly changes its business model.

Xeriant, a tiny stock a reader recently emailed about, offers an interesting example.

According to its SEC filings, the company previously operated under the name Banjo & Matilda, selling luxury cashmere apparel. It eventually shifted into aerospace technology, including aircraft capable of vertical takeoffs and landings. Today, it focuses on advanced building materials made from recycled products.

Now, changing business models isn’t necessarily bad. Plenty of successful companies have reinvented themselves over the years.

But when a tiny company repeatedly jumps between unrelated industries, investors should start asking questions.

What happened to its previous businesses? Did they generate meaningful revenue? Has management demonstrated an ability to execute on its plans? And perhaps most importantly, what experience does the current leadership team have in its latest industry?

Look at management’s background, previous accomplishments, and track record of delivering on promises.

A company’s investor presentations might lay out an incredible vision for the future. But its history can tell you a lot about management’s ability to turn that vision into reality.

In fact, the SEC identifies frequent changes in a company’s name or business as a warning sign that deserves additional scrutiny.

The lesson: A company can change direction and become successful. But management must show it can execute, regardless of the industry.

3. The company has a great product but can’t make money from it

This might be the biggest trap penny stock investors fall into. Having a promising product and building a profitable business around it are two very different things.

First, the company needs customers willing to buy its product. Then it needs to manufacture that product at a competitive cost, establish a reliable supply chain, and deliver orders on time.

And it needs to do all of that while generating enough revenue to cover its expenses.

That’s why investors should be skeptical of companies that constantly talk about their total addressable market—the revenue they could theoretically generate if they captured the entire market.

A $100 billion market opportunity sounds fantastic. But if the company is generating little or no revenue, investors need to understand what’s preventing it from turning that opportunity into actual sales.

The lesson: Focus on what the company is accomplishing today—and whether it’s making measurable progress toward profitability.

4. The company needs money, and shareholders could pay the price

This brings us to another major risk: share dilution.

Developing new technology is expensive. Companies need money to fund research, hire employees, manufacture products, and expand their operations.

Larger, established businesses can often finance those expenses through their existing cash flow. But many penny-stock companies aren’t profitable yet. That means they need to raise additional capital, frequently by issuing new shares.

Here’s a simple example.

Imagine a company has 10 million shares outstanding, and you own 100,000 of them. That means you own 1% of the business.

Now imagine the company issues another 10 million shares to raise money. Your original 100,000 shares still exist, but they now represent just 0.5% of the company. Your ownership stake has been cut in half.

Of course, issuing shares isn’t always bad. If management uses that capital to grow the business and create substantial value, the investment can still work out.

The problem comes when companies repeatedly issue new shares just to keep the lights on, without generating meaningful business progress.

Investors can end up owning smaller and smaller pieces of a company that’s struggling to survive.

Before buying a speculative stock, look at how much cash the company has, how quickly it’s spending that money, and whether its outstanding share count keeps increasing.

Also check for convertible debt and warrants that could result in additional shares being issued.

The lesson: A company’s growth potential means little if it can’t finance its business without continually diluting shareholders.

5. Exciting headlines are driving the stock more than actual results

Finally, watch out for stocks that seem to move mainly on promotional headlines.

This is especially common among penny stocks because their low trading volume makes them particularly sensitive to sudden bursts of buying activity.

A company announces a potential partnership, an exciting new technology, or plans to enter a rapidly growing industry. Investors pile in, hoping to get ahead of the next big opportunity. The share price surges.

But what happens after the excitement fades?

If the announcement doesn’t lead to meaningful revenue or profits, there’s often little to support the higher valuation.

And in the worst cases, this enthusiasm can be exploited through so-called pump-and-dump schemes, in which promoters use misleading claims to drive up a stock before selling their shares to unsuspecting investors. The SEC warns that thinly traded microcap stocks are particularly susceptible to this kind of manipulation.

Investors need to separate an exciting development from actual business results. A partnership announcement might be promising. But how much revenue will it generate? A major purchase order sounds impressive. But can the company fulfill it profitably? And when management makes an ambitious forecast, does the company’s subsequent performance support that prediction?

Over time, you want to see announcements turn into sales, improving margins, and a stronger financial position.

The lesson: Let the company’s financial performance—not the excitement surrounding its stock—guide your investment decisions.

How to approach penny stocks without gambling your portfolio

None of these warning signs automatically disqualify a company as a good investment.

Some of the world’s most successful businesses started small, needed outside financing, and took years to become profitable. And finding a promising company before the rest of Wall Street discovers it can lead to enormous returns.

But speculative investing requires discipline.

If you’re considering buying a penny stock, start by determining how much money you’re comfortable risking. For particularly speculative investments, that might mean taking a very small position—one you could afford to lose entirely without seriously damaging your portfolio.

You’ll also want an exit strategy before buying. With thinly traded stocks, even stop-loss orders may execute well below your intended exit level, so position sizing matters even more.

And if one of these stocks suddenly surges on positive news, consider taking some profits off the table rather than assuming the rally will continue indefinitely.

Most importantly, keep reassessing your original investment thesis. Is management delivering on its promises? Are revenues improving? Is the business getting closer to profitability? Or is the company still asking investors to be patient while it promises bigger things are just around the corner?

Penny stocks can deliver life-changing returns. They can also wipe out your investment.

The best way to improve your odds is to look past the exciting story and focus on the fundamentals: the people running the company, the money coming in, and the company’s ability to turn its potential into real profits.

Want to find out how Frank identifies the most promising growth stories… before the rest of Wall Street catches on? Check out his 6 principles for finding great stocks.