Penny stocks are cheap and often see massive gains, but they’re also very risky. Here’s what you should know before investing.



On the plus side, penny stocks offer a cheap chance to buy a winner; on down side, they can be hard to research and trade. Bill Oxford/Getty Images


© Bill Oxford/Getty Images
On the plus side, penny stocks offer a cheap chance to buy a winner; on down side, they can be hard to research and trade. Bill Oxford/Getty Images

  • Penny stocks are securities that trade at less than $5 per share, often in unsupervised over-the-counter markets.
  • Penny stocks are considered lucrative but high-risk investments: volatile, illiquid, and often subject to scams.
  • Investors interested in penny stocks should deal with those listed on larger exchanges and sold by established brokers.
  • Visit Insider’s Investing Reference library for more stories.

Penny stocks have become more popular than ever, tempting investors with a low cost of entry and the prospect of significant financial gains. Stories of shares making gains of over 4,000% in just months add to their appeal, and new trading technology makes it easier than ever to enter the market.

Loading...

Load Error

But while they can be lucrative, penny stocks come with significant risk. Potential investors should be careful to understand what they’re getting into.

What are penny stocks?

Penny stocks refer to company stocks that cost, if not merely a penny, a pretty low amount. In the US, the SEC defines them as those that trade for less than $5 per share. Because they’re often sold “over the counter,” rather than in centralized stock exchanges, they are also sometimes called OTC stocks. 

Depending on the issuing company’s capitalization — the total dollar value of its outstanding shares — penny stocks can be referred to as small-cap, micro-cap, or nano-cap stocks.

Penny stocks are usually issued by new or very small companies. These companies often don’t have the kind of track record that generates investor interest, which is why their shares are sold for so little. Larger, more established companies may also have stocks trading under $5 when they are facing financial trouble or approaching bankruptcy. 

Penny stocks trade differently from other stocks 

Some penny stocks are listed on major exchanges, like the New York Stock Exchange (NYSE).

Much more often, however, they are traded over the counter, through a network of brokers and dealers, rather than on a centralized market. The OTC Link LLC and OTC Bulletin Board are two of the major exchanges for penny stocks.

Who trades in penny stocks? 

Penny stocks attract individuals who are comfortable with high-risk trading — usually very experienced investors who are able to distinguish small, valuable startups with great potential from low-value companies. 

Loosely regulated hedge funds, short-sellers, and speculators are all other common participants in the penny stock market. Some mutual funds, like the Fidelity Low-Priced Stock Fund (FLPSX) and ETFs, trade primarily in penny stocks.

What are the benefits of investing in penny stocks?

Penny stocks are cheap 

You would have to spend thousands of dollars to get a lot of shares of Facebook or Google, but you can spend a lot less to get in on the penny stock market. The idea of buying shares of a solid startup at $0.20 and cashing out at $1 — or even much more — is tempting to many investors.

You might get into a profitable company on the ground floor 

It’s every investor’s dream: Catch an unknown star before it gets discovered, and ride it when it starts to soar. Strange as it sounds, Amazon (AMZN) was one such at one point. Back in 1997, you could buy Amazon shares for $1.68; as late as 1998, you could get them for $5. Amazon currently trades at over $3,000…get the point?

Trading can be thrilling

Penny stock trading can be fast and furious. “So when they move 20%, 50%, or even 100%, they often produce gains within days or hours, or even within minutes,” says Peter Leeds, author of “Penny Stocks for Dummies,” adding, “that’s a lot more exciting than you will ever see from any big-name stocks like IBM or McDonald’s.”

Why are penny stocks risky?

The companies are obscure, troubled, or untried 

Being unknown can be a good thing. As noted above, Amazon was an obscure company at one point. 

But most companies do not perform as well as Amazon. The vast majority of obscure, troubled, or untried companies are not great investments. Many penny stocks are in hot industries — like cannabis or info-tech — but that doesn’t mean the individual firm is a winner.

Volatile prices

Volatile prices can deliver huge gains to investors. But they can also deliver massive losses. Those 20% to 100% price moves aren’t always in an upward direction. The SEC warns that penny stock investors “should be prepared for the possibility that they may lose their whole investment.”

Illiquidity

Liquidity refers to how easily securities can be sold. Stocks can be characterized as less liquid when it’s not easy to sell them without taking a loss. Since relatively few people trade in penny stocks, it can be hard to unload them, even when — especially when — they start to drop.

Lack of transparency and information

There tends to be less information available on companies in the penny stock market than for those on other securities markets.

Companies trading on the large, centralized exchanges file their financial reports to the SEC, which are available to investors for free. Until September 2020, these reports were not required of companies issuing penny stocks.

The SEC has recently issued new rules to increase information and improve investor protections. Brokers are now prohibited from quoting a price for a penny stock unless the issuing company has publicly released its current financials. 

So there is a movement towards transparency. Still, up-to-date and unbiased information on a penny stock can be hard to come by, and often no regulator is demanding or evaluating a company’s filing.

High risk of fraud

The lack of information and transparency is one reason that fraud is so common in the penny stock market. 

One common scheme is called the “pump and dump.” Scammers purchase huge quantities of a stock and then share misleading information to make it attractive to other investors. In some cases, individuals even create fake shell companies that do not actually do any business or have any assets. 

Believing that the stock is a good investment, investors buy shares, causing the price to rise. The scammers then sell off their shares, earning huge profits and causing the share price to collapse. Investors are then left holding worthless stocks.

As Brenda Hamilton, founder of Hamilton & Associates Law Group, previously told Business Insider: “If you look at some of these companies, it’s ridiculous. You have undisclosed promoters, you have bad actors, you have felons, you have securities violations. And investors don’t know about any of that.”

How to invest in penny stocks

If you’re still game to play penny stocks, bear these thoughts in mind:

  • Only buy the best. Look for very high-quality companies with rock-solid balance sheets.  Make sure you can find up-to-date financials or analyst reports so you can make well-informed decisions.
  • Avoid “dark markets.” Companies trading on the large exchanges, like the NYSE and Nasdaq, have to follow strict regulations to be listed, as do those on the OTC Bulletin Board and the OTC Link LLC. But avoid other over-the-counter exchanges, like the OTC-QX, the OTC-QB, and the Pink OTC Markets. They’re commonly called “dark markets” because their lack of listing requirements attracts less legitimate companies that have a higher risk of fraud.
  • Use established stock brokers. Make sure any broker that you use follows the SEC’s rules. They should be willing to provide you with written research about the investments they’re promoting.
  • Do your own research. The way to avoid scams is to research companies thoroughly. Don’t trust unsolicited emails, chatrooms, or cold calls. Instead, contact your state securities regulator or the SEC to get accurate information about a company you’re interested in.
  • Only invest what you can afford to lose. Don’t put all your (nest) eggs in the penny stock basket. It can be a good play with your “fun money,” but this isn’t the place to invest your retirement savings. 

The financial takeaway 

Trading in penny stocks is not for the faint of heart. Successful investors tend to be experienced and have a sophisticated understanding of the field. 

They’ve often developed comprehensive methods of analysis to be able to distinguish between a good deal and a scam. And they can devote a lot of time to trading and watching the fast-moving market.

If you’re new to investing, trading penny stocks is probably not the right place to start. But if you’re confident that you understand the risks, that you can find an honest broker, and that you’re able to spot a legitimate but undervalued company, it could work for you. 

You might even find the next Amazon.

Related Coverage in Investing:

Why invest in the stock market? Because it can be more dangerous not to

How to invest in stocks, even if you’re starting from scratch

Sin stocks are shares in companies whose business can be considered unethical — here’s why they’re so enticing 

What are junk bonds? A risky yet high-yield investment that can bring rewards if you’re willing to take the chance

How Instagram’s penny stock king became a self-employed multimillionaire

Continue Reading

Source Article