What You Need To Know About Investing In Penny Stocks

By:    Updated: March 30,2017

Perhaps more than any other financial product, there is an incredible amount of misinformation involving penny stocks. Otherwise intelligent investors who swear by penny stocks will tell you that Intel, Lucent, Microsoft and any number of other great companies started as penny stocks. They are wrong. Others, who like the idea of spending $1,000 to own 1,000 or even 10,000 shares of a stock, become blinded by the potential that that $1,000 investment will become $10,000 or even $100,000. That rarely happens. We'll start by defining penny stocks. Then we'll lay out the benefits associated with them and offering tips for those who want to buy them.

What's A Penny Stock?

According to the Securities & Exchange Commission, any stock under $5 is a penny stock. Informally, some set the price at $3 while others say it is $1. The terms “penny stock” and “micro-cap stock” are often used interchangeably, but they are not the same thing. Micro-cap stocks are named based on their market capitalizations, but penny stocks are looked at in terms of their price. A stock with a market capitalization between $50 million and $300 million is a micro cap, while a stock of less than $50 million is a nano cap. However, penny stocks and micro-cap stocks have something in common. They are much riskier than regular stocks.

Why Are Penny Stocks Risky?

  • Information. There Isn't A Lot Of It. The best investors – think Warren Buffett – don't invest in a company until after they have done an enormous amount of research. When it comes to penny stocks, information is much harder to come by. Penny stock companies don't have to file with the Securities and Exchange Commission and are not scrutinized as much as stocks on exchanges such as the New York Stock Exchange and Nasdaq. Additionally, the information you can find about penny stocks often is not from credible sources.
  • No Minimum Standards. If you want to follow penny stock trading, you go to the OTC Bulletin Board, a service offered by National Association of Securities Dealers that provides real-time quotes, volume information and selling prices. Stocks on this board do not have to fulfill minimum standard requirements and this is sometimes why a stock is no longer on one of the major exchanges. Minimum standards are important because they provide security for some investors and serve as a benchmark for some companies.
  • No History. Many penny stock companies are either young or on shaky financial ground. Some of these companies have no or poor track records and that makes it difficult to determine a stock's potential.
  • Little Liquidity. When stocks have little liquidity, they are more difficult – or even sometimes impossible -- to sell, forcing sellers to dramatically lower prices before buyers can be found. These stocks also provide opportunities for some traders to manipulate stock prices, buying large amounts of stock, hyping it and then selling it after other investors find it attractive. This is known as a pump and dump.
  • Penny Stock Frauds. Related to stock manipulation, there are many scams related to penny stocks. Some penny stock companies pay others to recommend the stock in newsletters, spam email and traditional media such as financial TV and radio shows. Press releases are sent to financial journalists touting “the next big thing.” Sometimes companies that are allowed to sell stock to foreign investors will sell penny stocks at a discount to dishonest offshore brokers who resell them to American investors for a big profit.

Still Interested In Penny Stocks?

Penny stocks are risky and a lot of people have lost a lot of money investing in them. However, while they are not for all investors, some people have made a lot of money trading penny stocks. If you want to give it a try, here are some tips:

  • Information is power. Find out as much as you can about penny stocks and their pros and cons. Understand that penny stocks are traded over the counter, not on a stock exchange. Brokers receive commissions based on the transaction.
  • Carefully research brokers who specialize in penny stocks and after you have done your due diligence, hire one. Run from one who tells you that you're getting a sure thing.
  • If you don't want to use a broker, subscribe to an online service that provides you with a list of available penny stocks.
  • Familiarize yourself with the companies offering penny stocks. Like with any other company stock, make sure the companies you invest in make a product or offer services that are in demand and are led by executives with a good track record.
  • Beware of penny stock companies that once were listed on a major exchange. Chances are, those companies are experiencing significant financial trouble.
  • Because penny stocks are risky, they should make up less than 10 percent of your investment portfolio.

The bottom line is that investing in penny stocks is risky. However, if you decide to take the plunge into penny stock investing, make sure that you do all of your homework ahead of time. This will help to reduce the risk that you lose a boatload of money.

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