If you’re looking to break into a new market, trading penny stocks is one way to fire up your investments.
Before you jump into the penny stock world, though, it’s important to learn the basics first and be aware of the characteristics of these low-priced stocks to see if they are right for you.
Here are a few points that investors should keep in mind:
— What are penny stocks?
— The risk of trading penny stocks.
— Understanding volatility.
— Watch out for scams.
— How to trade penny stocks.
— Picking the right companies.
What Are Penny Stocks?
Penny stocks are shares of small companies with a stock price of less than $5 per share. The low-priced stock allows traders to purchase many shares with the anticipation that the price will grow.
While some penny stocks trade on large exchanges — like the New York Stock Exchange (NYSE) or the Nasdaq — most are traded in the over-the-counter market via the OTC Markets Group (ticker: OTCM).
The OTC Markets Group breaks down over-the-counter stock trading into three tiers:
— Stocks in the first tier, OTCQX Best Market, are established, investor-focused domestic and international companies that meet high financial standards, follow best practices for corporate governance, are compliant with U.S. securities laws, are up to date with their disclosures, and have a professional third-party sponsor introduction. You won’t find penny stocks on this list.
— The next tier, OTCQB Venture Market, is composed of early stage and developing domestic and international companies that are current in their reporting and undergo an annual verification and management certification process. They also have to meet a $0.01 bid test and can’t be in bankruptcy.
— Stocks in the Pink Open Market, don’t have any financial standards or disclosure requirements. Companies traded on this market include penny stocks, shell companies, foreign companies with limited U.S. disclosures, distressed and delinquent companies, as well as “dark companies” unwilling or unable to provide information to investors.
Risks Associated With Penny Stock Trading
Trading in penny stocks has become a popular way to see quick returns with investing small amounts of capital, which can be an attractive strategy.
But some chartered financial analysts say that for the vast majority of investors, trading in penny stocks is wholly unsuitable.
It can often be the case that penny stocks do not have to file reports with the U.S. Securities and Exchange Commission, meaning stock market investors will have difficulty determining the overall financial health of a business.
Penny stock quotations are often difficult to find. If a company is new, it may not have a financial history or enough of a track record for investors to assess its financial stability.
Penny Stocks Can Be Highly Volatile
The price of a volatile stock will fluctuate from high to low or vice versa at a rapid pace — and that can be a particular problem among penny stocks.
Liquidity is also a concern. “In order to sell your penny stock that has appreciated by 1,000% you have to be able to find someone who is willing to pay that price for it, which is not likely to happen,” says Joshua Simpson, investment advisor representative with Lake Advisory Group.
[READ: How to Become a Day Trader.]
Beware the ‘Pump and Dump’ Scam
Running into scammers is also a risk to trading penny stocks.
“The most infamous and popular scam with penny stocks is the ‘pump and dump,’ which was made popular by the mob decades ago,” Simpson says. With this type of scam, the basic idea is that a person or group will drive up the price of a penny stock and then sell it after raising the price significantly.
Offshore brokers often use the informational blind spot that can come with penny stocks to pressure people with limited financial knowledge and investing experience into buying, enabling the broker to take advantage of higher-than-normal commissions, Simpson says.
Penny stocks can be ripe for pump-and-dump scams because the buy-in is much more accessible, making it easier to influence investors, says Aaron Barr, chief technology officer with PiiQ Media.
He says the market is seeing a significant amount of activity on social media channels that inflate the investment potential for some penny stocks and the number of shares traded each day.
One way to avoid scammers is to ignore social media conversation regrading penny stocks, Barr says. “There is likely some good information, but it’s mixed and diluted with a lot of false or misleading information, and working to discern the difference is just too time consuming,” he says.
In addition to pump-and-dump schemes, penny stocks have been ripe for insider trading, says Stuart Titus, CEO of Medical Marijuana (MJNA), which is a penny stock traded over the counter.
How to Trade Penny Stocks
Investors should access and evaluate as much information as they can about a company before buying any stock. This holds true especially for penny stocks.
Research a company’s corporate earnings, profit margins and the share price. If there are company filings with the SEC, those offer a great place to start. If there are no SEC filings, get in touch with your broker to see if it can provide any information.
A great way for beginners to trade in the penny stock market is to first get comfortable trading in simulation accounts, otherwise known as paper trading. This method is the safest way to practice trading penny stocks without the risk of losing real money. By becoming familiar with price fluctuation patterns and reflecting on the mistakes you made while using a mock account, you can learn the ins and outs of this market.
How to Choose the Right Penny Stocks
Penny stocks are highly speculative, and Simpson says there’s no method for choosing the right one. People who aren’t experienced investors that can afford to lose their money shouldn’t invest in them, he adds.
“In my opinion, you would be better off taking the money you want to invest in penny stocks to the casino or horse track and betting it there,” Simpson says. “At least that way you would be able to have a little fun with (the) money before it disappears.”
Not everyone is so pessimistic on penny stocks.
“With a penny stock, investors will look for a new product, new idea, or a way to take something existing and do it better,” Titus says. “Those with solid track records of solid performance over time will be listed on higher exchanges and likely have far less price volatility.”
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Update 04/21/21: This story was published at an earlier date and has been updated with new information.