Small companies can be a good investment, but they can also be a risky place to put money. Some investors are willing to take the risk and invest in what are called ‘penny stocks’. A core characteristic of penny stocks is that they cost less than traditional stocks. These stocks usually sell below $5 per share, which is much cheaper than major stocks like Amazon or Tesla.
How Do Penny Stocks Work?
Penny stocks are cheaper than traditional stocks and may trade for anywhere from a fraction of a penny to $5. That said, penny stocks are usually ones that trade below $1. They also don’t usually trade as many shares as traditional stocks.
Since penny stocks are a risky investment, they don’t trade on traditional exchanges like NASDAQ or the New York Stock Exchange. Instead, they’re traded on the over-the-counter market, also known as pink sheets.
OTC markets trade securities that aren’t listed on major stock exchanges and are decentralized, meaning they don’t have a physical location.
An important thing to know about penny stocks is that they tend to be speculative, meaning they have potential for success, but no track record of success yet. For example, it could be a new company that hasn’t been able to show consistent growth yet. That said, when penny stock investing goes right, that speculation could lead to generous returns.
The Risks of Penny Stocks
Penny stocks are a risky investment, so they’re not suitable for most investors. Those who have a low risk tolerance or need their money for short-term goals may not be cut out for this type of investment.
Why are penny stocks so risky? For one, investors often don’t have enough information about the company to determine their odds of success. Penny stocks ate also notorious for being vulnerable to pump and dump schemes. This is when a group of individuals plan to buy a stock and then artificially inflate the value of that stock through means like telemarketing, newsletters, or internet fraud. The said group tries to convince other people to buy the stock and as soon as the price shoots up they sell and pocket their profits. The price of the penny stock usually plummets after that.
Another form of fraud that’s common with penny stocks is “short and distort”, which is the opposite of pump and dump. Fraudulent individuals will short the stock by betting the price will fall, circulating negative information about a penny stock to get the price to drop, and then pocketing their profit.
Penny stocks are vulnerable to fraud because they aren’t held to the same standard as ones listed on the stock exchange. For example, the companies offering penny stocks may not share as much information about their financial health and governance.
Not being able to sell penny stocks due to low liquidity or a lack of demand is another risk. If the price of a penny stock increases, but an investor doesn’t have anyone to sell to while the price is high, those gains are meaningless. Checking the trading volume of the stock on a daily or weekly basis can help an investor gauge whether their shares will be easy to sell.
Investors can make a profit with penny stocks, but it requires a lot of analysis and a healthy dose of luck. This analysis can be done by reading up on financial stats, requesting financial data from the company if it’s not publicly available, and checking SEC filings.
How to Buy Penny Stocks?
Investors can invest in penny stocks by first finding a brokerage that specializes in OTC trading. The subsequent steps are similar to trading traditional stocks: find the ticker symbol of the penny stock on the OTC Bulletin Board (OTCBB) or the OTC Markets Group, decide on the quantity, and then purchase.
Keep in mind many brokers charge more for penny stock trades, so investors want to compare fees before jumping in. Also look out for surcharges on large orders so fees aren’t eating into profits. Finally, as mentioned earlier, research is essential before investing in penny stocks. Once again, penny stocks are unsuitable to the vast majority of investors.
