When you see stocks like Amazon and Google parent Alphabet trading for thousands of dollars, investing can seem out of reach. Those high prices may tempt you to seek out a bargain. Enter penny stocks.
Penny stocks seem like an opportunity to buy into an up-and-coming company for dirt cheap. At penny stock prices, you can afford to buy hundreds or even thousands of shares.
But watch out: Trading penny stocks could easily leave you broke. Here's why it's so easy to lose money buying penny stocks.
What Is a Penny Stock?
The U.S. Securities and Exchange Commission defines a penny stock as one that trades for $5 or less per share. Most investors, though, take a narrower definition. Many define it as one that trades for under $1.
The low share price isn't the only thing that defines a penny stock. You can find stocks trading for under $5 a share on major stock exchanges, like the Nasdaq or New York Stock Exchange (NYSE). But most investors don't consider these to be penny stocks.
Penny stocks generally trade on the over-the-counter (OTC) market. The transaction takes place between the broker-dealers for the buyer and seller. They use the OTC market to name their prices. There's no central exchange facilitating the trade, which can happen without anyone else knowing the transaction price.
The transaction may feel the same as it does when you invest in stocks listed on a major exchange. You can typically use whatever brokerage account you normally use to trade stocks. You place the order in the same way you would for any other stock.
The only thing that may stand out: Your broker is required by the SEC to obtain your signature on a risk disclosure document before placing your first penny stock order.
Penny stocks have a market capitalization â€" meaning the combined value of all of the company's publicly traded shares â€" of less than $300 million. To be included on the S&P 500 index, which is generally considered a barometer for the U.S. stock market, a company needs to have a market cap of at least $11.8 billion.
Are Penny Stocks Worth It?
If you're wondering, 'Are penny stocks worth it?', the answer is pretty much a resounding, 'NO!' Here's why penny stock is among the riskiest investments you can make.
Lack of Transparency
Big companies that trade on major stock exchanges are required to file lots of information with the SEC. The information is publicly available at SEC.gov.
But let's say you jump into the penny stock market by investing in a company with less than $10 million in assets and only 2,000 individual investors. That company may not have to file with the SEC at all. Plus, investment analysts and news reporters scrutinize bigger publicly traded corporations, while paying far less attention to small companies. A company with under $10 million in assets is unlikely to draw much focus.
Companies traded on over-the-counter exchanges are subject to far less oversight than companies on a big stock exchange. Many penny stocks trade on the pink sheets, an electronic stock listing service that gets its name because it used to be published on â€" you guessed it â€" pink sheets. Companies listed on the pink sheets aren't required to disclose much information.
Few Minimum Listing Requirements
Any stock that trades on major exchanges is subject to strict requirements. For example, for a stock to start trading on the NYSE, these are just a few of the requirements:
- At least 400 shareholders who each own at least 100 of the company's shares.
- A minimum of 1.1 million publicly traded shares with a value of at least $40 million.
- The stock price must be at least $4 per share.
The companies that issue penny stocks usually can't meet these stringent listing requirements.
Maybe they have no proven track record. Penny stocks are often issued by companies that have never earned a profit.
Or maybe they do have a track record, but it's a troubled one. If a stock listed on the New York Stock Exchange or Nasdaq falls below $1 per share and stays there for an extended period, it will be delisted. Then, you'll see it on the OTC markets.
High Volatility
Penny stocks are a highly speculative investment. A single piece of good or bad news can make or break your investment in a penny stock. The companies are so small that their success may be contingent on getting FDA approval for a single drug or obtaining a patent. A relatively small change in demand for the stock can also result in major gains or losses.
When you have a stock price that increases from a few cents to a few dollars, you can earn massive profits. Meanwhile, with major stocks, if the price goes up by a few bucks, that won't amount to huge returns.
But remember: It's incredibly difficult to find good penny stocks because they're issued by unproven or struggling companies. It's far likelier that the price falls to zero and you lose your entire investment than it is that you'd get rich.
Low Liquidity
Most penny stocks have a low trading volume. That means they trade infrequently, which is bad news for you when you want to sell.
Let's say you owned 5,000 shares of a company, but the trading volume is only 1,000 per day. You'd realistically have to wait five days to sell all your shares. Even then, you may have to sell for much lower than your ask price.
In investor speak, this is known as low liquidity: To quickly convert your investment to cash, it's likely that you'd have to sell at a low price and lose money.
Rife With Fraud
The world of penny stocks is filled with fraudsters who prey on inexperienced investors. Two of the most common penny stock scams are the pump and dump and the short and distort.
Pump and dump schemes: Scammers drum up hype about a company to drive up share prices. They may say that a company has found the cure for COVID-19 or that it's discovered a new gold mine. Then they offload their inflated shares on unsuspecting investors.
You may find scammers raving about a particular stock in a penny stock newsletter, on message boards or legitimate-looking research. Another common tactic is to call investors to drum up interest in penny stock companies, as occurred in the movie 'The Wolf of Wall Street,' which is based on the true story of disgraced stockbroker Jordan Belfort.
Short and distort: Investors use a maneuver called short selling when they're betting a stock's value will drop or become worthless. When you short a stock, you essentially borrow shares in hopes that the price will drop. Then you can buy it back at a lower price to close out your position. With the short-and-distort scam, fraudsters short the stock, then spread false negative rumors about the company. When share prices plummet, they profit.
But Couldn't I Pick the Next Tesla?
Theoretically, yes. But that's highly unlikely. Most wildly successful companies were never traded as penny stocks.
Microsoft, Amazon, Facebook and Tesla all made huge profits for early investors. But they were mainstream stocks from the start. They traded on major exchanges from the beginning, and each had an initial public offering (IPO) price above $15.
6 Rules to Follow if You're Determined to Trade Penny Stocks
We hope we've convinced you that buying penny stocks isn't worth the risk. You're much more likely to profit by investing in an ETF or mutual fund that represents the entire stock market.
But what if you're determined to do it anyway? Follow these rules to mitigate the risks.
1. Only Invest What You Can Afford to Lose
Would you be OK with losing this money at the poker table? Don't invest it in penny stocks if the answer is 'no.' Your odds of losing money are substantially higher than your chances of profiting big time.
2. Research Before You Buy
If you can't obtain information about a company from SEC filings, that's a sign that you should pick a different stock. Also, make sure you understand the basics of the industry and how the company makes money. A little knowledge will help you see through overhyped claims pushed by penny stock promoters.
3. Look for Stocks With a Decent Market Capitalization
Most penny stocks are either nano-cap companies (market capitalization of $50 million or less) or microcap companies (market capitalization of $50 million to $300 million). To mitigate the risk, look for stocks with a market cap on the higher end of that spectrum.
4. Pay Attention to Trading Volume
A stock's trading volume shows how many shares are bought or sold on a given day. Look for penny stocks with a minimum trading volume of 100,000 to 200,000 to improve your chances of having a willing buyer should you need to sell.
5. Use Automatic Stop Loss Triggers
You may want to set up stop loss triggers if you're determined to buy penny stocks. If your share prices fall by the amount you specify, your brokerage will automatically put them up for sale. But remember: The low liquidity can make it tough to sell penny stocks.
6. Put No More Than 10% of Your Portfolio in High-Risk Investments
High-risk investments should never take up more than 10% of your portfolio at the absolute max. That's 10% for ALL the risky investments. You don't get 10% for penny stocks, 10% for Bitcoin and 10% to invest in marijuana stocks.
It's essential to keep the other 90% in a diversified portfolio that's invested across the stock and bond markets.
Want to Buy Cheap Stocks? Consider This Alternative
If you want to start investing but don't have much money, consider buying fractional shares instead of penny stocks. You decide how much you want to invest in a stock, and then you get a corresponding fraction of a share. If Amazon is trading for $3,000 a share and you invest $30, you'd get 1/100th of a share. Many mainstream brokerages and investment apps allow for fractional investing.
The bottom line: Be aware of all the risks before investing in penny stocks or anything else. If you can't afford to lose money, penny stocks are best avoided.
Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. Send your tricky money questions to [email protected] or chat with her in The Penny Hoarder Community.
This was originally published on The Penny Hoarder, which helps millions of readers worldwide earn and save money by sharing unique job opportunities, personal stories, freebies and more. The Inc. 5000 ranked The Penny Hoarder as the fastest-growing private media company in the U.S. in 2017.
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