Penny stocks are shares of small companies that trade for less than $5 per share. They are highly speculative investments, meaning they carry a high risk. Usually, traders looking for short-term gains use penny stocks rather than long-term investors looking to build wealth.
However, penny stocks often lure investors because they are relatively cheap and offer potentially high returns. Most people have a story of a relative who knows about an outstanding penny stock that’ll cost next to nothing, promising some way to get rich quickly. While this story is seductive, it’s far from reality. Investors must know how they work before using penny stocks to make quick gains and the risks involved.
What Are Penny Stocks?
Penny stocks are low-priced securities that trade for less than $5 a share, though usually, they trade for less than $1.
Penny stocks are generally considered to be highly speculative and risky investments. Small, unknown companies issue most penny stocks with no operating history. In addition, these companies often lack the financial resources to continue operating for very long and are susceptible to fraud.
Despite the risks, some investors are attracted to penny stocks because they offer the potential for large profits in a short period. For example, if a penny stock’s price doubles from $0.30 per share to $0.60 per share, that’s a 100% return on investment on just a $0.30 price increase. Of course, the flip side is that you could lose your investment just as quickly.
Exploring Penny Stocks & How They Work
Although some penny stocks trade on major exchanges, such as the New York Stock Exchange or Nasdaq, most penny stocks trade on the over-the-counter (OTC) market, through the OTC Bulletin Board (OTCBB), or on the pink sheets.
Penny stocks on the OTC market do not have the exact regulatory requirements as companies listed on major exchanges. Companies that list their shares on the major exchanges are subject to a high degree of regulatory scrutiny; these publicly traded companies must meet minimum listing standards and provide regular financial reports to the Securities and Exchange Commission (SEC).
In contrast, over-the-counter stocks have fewer hoops to jump through, as they do not have to meet minimum listing requirements. However, penny stocks that trade on the OTCBB must file financial statements with the SEC, while penny stocks listed on the pink sheet are not required to.
Because many penny stocks do not have to report periodic financial statements to a regulatory agency, it can be difficult for investors to find adequate information to make informed investment decisions on these securities. This lack of knowledge is one of the reasons penny stocks are risky investments.
Penny Stocks Are Highly Speculative
As noted above, penny stocks are highly speculative investments often bought and sold by traders who want to make short-term gains. Because of this potential for significant, short-term gains, many people view penny stocks as a way to get rich quickly. However, this is far from the case; penny stocks carry a high degree of risk and, as such, should be traded by people with the time, money, and risk tolerance to dabble in this market. You should only invest in them if you will lose substantial money.
? Recommended: The Difference Between Speculation vs. Investing
Who Can Buy Penny Stocks?
Anyone can buy and sell penny stocks, though it is recommended that they have the appropriate risk tolerance before investing in these speculative securities.
To trade penny stocks, you must open an account with a broker that offers OTC trading. Many online brokers offer this service, but do your research before selecting one, including the fees they charge. Once you have an account, you can start buying and selling penny stocks. Just remember to be careful, as they can be very risky.
Pros of Penny Stocks
High Reward Potential
There is a belief by some penny stock traders that these small securities have more room to grow than large stocks, thus resulting in significant, short-term price appreciation. The potential for short-term gains means that penny stocks may provide high rewards despite their risks, mainly if traders utilize buying on margin to make their trades.
Enjoyment
Just as some people like to gamble, others like to trade stocks and other securities for fun. Many would consider analyzing stock charts, reading up on unknown companies, and making bets as hobbies. Traders like this might consider penny stocks as “fun spending,” not long-term investing.
Cons of Penny Stocks
Small Likelihood of Success
Making money on a penny stock can be a rare occurrence. Investors should be aware of this, despite the tales of sudden wealth they may hear. Also, contrary to popular belief, success by investing in penny stocks can often take a long time.
Possibility of Losing it All
A small likelihood of success means that there will inevitably be many failures. It is common for small, unestablished businesses to fold and go under, flounder, or have unsuccessful stock. When stocks become worthless, investors lose all of their money.
Lack of Liquidity
Penny stocks usually do not have a lot of liquidity, meaning it can be challenging to find buyers when you want to sell. This can make it hard to get out of a position if the stock price declines.
Volatility
Penny stocks have high volatility, meaning their prices can change rapidly. This can happen in either direction, making them a problematic tool for building long-term wealth.
Scammers
The penny stock business is ripe with scammers and fraudsters. Numerous penny stock newsletters promise big wins, and “investors” manipulate the market and potential customers.
Researching Penny Stocks to Buy
It’s often difficult for investors to adequately research what penny stocks to buy and sell. Because many penny stock companies do not have to file reports to regulators, investors do not always have great information about the company’s finances, management, and operations.
One of the first things investors should do is check websites like the OTC Markets website to search for company information on the penny stocks they’re interested in. Once done, you can see if the companies have filed reports with the SEC through its EDGAR database. Using this company and financial information, you can develop a sense of the company’s finances and business practices.
Also, it may help to look at penny stocks that trade on exchanges such as the NYSE or NASDAQ. Because these stocks are required to file regular financial reports to the SEC, there is more easily accessible research investors can use to make investment decisions. Additionally, these companies are usually more stable and have more liquidity than penny stocks trading on the pink sheets or OTCBB.
Overall, you want as much public information as possible when researching penny stocks to buy and sell. When you make investment decisions with inadequate public information, you may open yourself up to relying on shady information that could come from paid promoters or fraudsters looking to pump and dump stock.
The Takeaway
The allure of making significant, short-term gains by trading penny stocks draws many people into this market. But with the potential of high rewards comes the increased risk and a probability that gains will be hard to come by. Before diving into penny stock trading, assessing your risk tolerance is essential to see if this strategy is right for you.
