What to Know About Investing in Penny Stocks

Penny stocks. You may have heard the term before. New and experienced investors alike can sometimes be drawn to them merely by their very low prices.

But before you jump into the penny stock world, it’s important to learn the basics and be aware of the characteristics — and pitfalls — of these low-priced stocks.

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Here are a few points that you should keep in mind:

— What are penny stocks?

— Risks of trading penny stocks.

— How to trade penny stocks.

— Bottom line.

What Are Penny Stocks?

Penny stocks are shares of small companies with low stock prices. While common sense might define a penny stock as one trading for less than $1 per share, some definitions are broader, including all stocks trading for less than $5 a 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).

Colloquially speaking, the term “penny stocks” generally doesn’t refer to well-established companies. So while a handful of legitimate, multibillion-dollar companies may have a stock price below $5 at any given moment — Ambev SA (ABEV) and Lloyds Banking Group PLC (LYG) are two current examples — considering them penny stocks violates the spirit of the term.

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. OTCQX doesn’t allow penny stocks.

— The next tier, OTCQB Venture Market, consists 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 have a bid of at least 1 cent per share and cannot be in bankruptcy.

— Stocks in the Pink Open Market have much looser, practically nonexistent financial standards and disclosure requirements. Companies traded on this market include penny stocks, shell companies, foreign companies with limited U.S. disclosures, distressed and delinquent companies, and “dark companies” unwilling or unable to provide information to investors. Here you will find many of the most speculative and risky penny stocks.

Risks of Trading Penny Stocks

Lack of transparency. Investors attracted to trading penny stocks often view them as a potential way to see quick returns with a small amount of capital. But some financial experts disagree.

“For the vast majority of investors, investing in penny stocks is wholly unsuitable,” says Robert Johnson, professor of finance at the Heider College of Business at Creighton University.

It’s often the case that penny stocks do not have to file reports with the U.S. Securities and Exchange Commission, and financial information provided by such companies is neither audited nor vouched for by the SEC. This means it can be difficult or impossible to determine the financial health of a business.

On top of that, 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 to assess its financial stability. “Penny stocks are the Wild West of the financial landscape. Investors should simply expect to lose their investment,” Johnson warns.

Volatility and illiquidity. 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 major concern, and it’s something investors new to penny stocks may overlook. While you may be able to find a willing seller when you buy into these thinly traded stocks, liquidity can be a very expensive problem when you go to sell.

Many OTC stocks may only have trading volume of a few dozen shares a day, or even go days or weeks without trading at all. If you can never sell your investment, your shares are, practically speaking, worthless. Or, if you manage to escape without a total loss, it may take selling at a rock-bottom price to entice a single buyer to pick up your shares.

Scams. Running into scammers is also a risk when trading penny stocks. One of the most popular cons in this arena is known as the “pump and dump” scam.

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 at the highest possible price.

Shady, offshore brokers may also 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.

Penny stocks can be ripe for pump-and-dump scams because the buy-in is much more accessible, making it easier to influence unwitting investors.

And, unfortunately, these age-old techniques often work. In April 2022, the SEC charged 16 defendants in nine different countries or territories with perpetrating a multiyear pump-and-dump scheme that netted them more than $194 million in illicit funds.

Yet another risk rears its head in the form of insider trading, when a company insider decides to buy or sell shares of their company’s stock at the expense of the investing public. The lower stakes and minimal regulation make small OTC stocks fertile ground for this type of abuse as well.

[See: 10 of the Best Stocks to Buy This Year.]

How to Trade Penny Stocks

If you’ve read this far and still want to know the best way to trade penny stocks, the answer is: carefully.

You should always access and evaluate as much information as you can about a company before buying any stock. This is especially true for penny stocks. The problem is, the information is much harder to come by. If there are no SEC filings, get in touch with your broker to see if it can provide any information.

Paper trading” can often be a useful exercise for beginning investors. Paper trading involves tracking the success of your hypothetical trades over time. Instead of actually buying $1,000 worth of stock, you’ll note the day and price per share of your imaginary $1,000 purchase and watch it play out over time.

Unfortunately, this exercise might not be useful at all when it comes to penny stocks with low volume. Purchasing shares might, in reality, force the price higher, while selling shares could require you to take a painful haircut on the price.

If you’re determined to get in on the penny stock game, do so after accepting the litany of risks that come with it. And use limit orders to buy and sell shares, since the low liquidity can make these markets very inefficient.

Bottom Line

In short, it’s much easier to do appropriate research on solid, established companies trading on major exchanges and making regular reports to the SEC than it is to do enough proper due diligence on a penny stock to buy it with confidence. Buying penny stocks is much more akin to playing the lotto or spinning the roulette wheel than it is to investing.

“Many people choose penny stocks as their first investments as there is such a low barrier to entry,” says Chad Willardson, founder of wealth management firm Pacific Capital. But “just because you are purchasing a large sum of shares for an affordable price does not equate to making quick money,” he cautions.

Aside from the low cost of entry, the allure of potentially quick profits is another temptation that sparks popular interest in this shady corner of the market.

“Remember, there is no shortcut or ‘get rich fast’ secret for investing. My rule of thumb is: If you don’t have at least a five- to 10-year time period to stay invested, then you should probably stay away from the stock market,” Willardson says.

[See: Artificial Intelligence Stocks: The 10 Best AI Companies.]

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What to Know About Investing in Penny Stocks originally appeared on usnews.com

Update 05/26/23: This story was published at an earlier date and has been updated with new information.

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