It's tough to succeed in penny stocks. Penny stocks are subject to all kinds of manipulations, and you’re going to need all your wits to make money in this neglected area of the stock market.
Here’s how to trade penny stocks — and not lose your shirt and pants.
What is a penny stock?
Most respected investors shun penny stocks — for good reason — though others may dabble in them. "Penny stocks" usually mean those trading for less than $5 per share, but the definition varies, and some brokers may set the bar at lower dollar amounts.
Their low price doesn’t inherently mean they’re poor investments, but penny stocks are usually priced low for a reason. They often represent terrible businesses, which may be on the verge of bankruptcy or engaged in fraud. Occasionally, there is a company that has fallen on hard times and could find its way back with a strong management team, or a start-up with genuine potential to grow. But those are the rare exceptions.
“Occasionally, there is a company that has fallen on hard times, or a start-up with genuine potential to grow. But those are the rare exceptions.”
The usual argument for buying penny stocks is that a small price increase can turn into a lot of profit. Buy a 30-cent stock and it only needs to go to 60 cents for you to double your money. But this reasoning is flawed. While that seems like a small move — the big stocks may move that much or more every day — it represents a 100% return. A company’s prospects have to change a lot — investors have to expect it to earn much more — for its stock to increase at that rate. A 30-cent move on a penny stock is not the same thing as on a higher-priced stock. And if a stock’s business isn’t very good, it’s even harder for the stock to double.
In addition, sometimes people buy penny stocks because they can purchase more shares. It may make people feel like they’re wealthy and stroke their ego to have a thousand or more shares, but your wealth is determined by the total sum invested, not how many shares you have.
There are numerous reasons to avoid penny stocks. In addition to being rife with scams, penny stocks are hard to research and tend to be harder to sell than those on the major exchanges. But that doesn’t stop all investors from trying their hand.
» Want to stick with established companies? Learn how to buy stocks
How to keep from losing your shirt
Still want to give it a go? Here’s some practical advice on how to invest in penny stocks.
Understand you’re probably a speculator, not an investor
If you’re buying penny stocks just because they’re low-priced or you got a “hot tip” from a newsletter or email, you’re a speculator. That means you’re in the stock for a quick “pop,” not to hold it forever. If you get your pop, it’s usually best to sell and move on, because penny stocks often go to zero over time.
In contrast, investors tend to buy higher-priced stocks because the companies have been strong performers over time. So investors have the luxury of taking a long-term buy-and-hold approach, because they’re investing for years, even decades, rather than speculating.
If you’re going to buy penny stocks, start small and move slowly. Make penny stocks just a fraction of your portfolio, ideally 10% or less of your individual stock holdings until you understand how they operate, what the pitfalls are and how you can stay safe. Scammers really are trying to fleece you here.
Beware the scams
Penny stocks reside in the backwater of the market, on the over-the-counter exchanges, not on major exchanges like the Nasdaq or the New York Stock Exchange. Outside of the big exchanges, companies don’t have stringent requirements for reporting their financials to investors and may not have to report them at all. Key information is often missing about the company, perhaps even what business it’s in. Penny stocks often trade on emotion, and emotion is easy to manipulate in the absence of facts.
“Penny stocks often trade on emotion, and emotion is easy to manipulate in the absence of facts.”
Penny stock fraudsters engage in two typical scams. The first is called “pump and dump.” A company or an individual shareholder might hire a promoter to send out emails and newsletters hyping a stock, hoping to push the price higher. The newsletter might make all kinds of promises about the company’s products or future (“the pump”) to get investors excited. When the stock moves up as a result of the new demand, the individual or company sells a lot of stock at a profit (“the dump”), ultimately causing the stock to fall
Then there’s the reverse of that, the “short and distort.” Here stock promoters “short” the stock — essentially bet that the stock will fall in price — and then try to push the stock lower by writing negative things about the company. This hype may allow short-sellers to make a profit on the declining stock.
Check the volume
You don't realize any profits until you close your position. If you have a penny stock that soars but you can’t sell your holdings, that higher price won’t do you any good. Before you buy stock, figure out its average daily trading volume. This number is reported on any good website that tracks stocks.
The higher the daily volume, the easier it generally is to sell. If a stock trades 1,000 shares per day and you own 10,000 shares, it would take on average 10 days to sell it all — if you were the only seller. If the stock spikes, you might not be able to sell in time to get that high price. Stick with modest amounts so that you can sell in a reasonable time frame.
Leave most of your nest egg in safe, sensible long-term investments like a Standard & Poor’s 500 index fund. These funds are easy to buy and lend the strength of America’s best companies to your portfolio, balancing risks you take with penny stocks.
Be prepared to research
Just like you would for normal stocks, you have to read any financial filings, which you should be able to obtain directly from the company, if not from the Securities and Exchange Commission. If there are no financial statements, that’s a huge red flag. Pass on that penny stock and move to another.
When researching penny stocks, you’ll have to disentangle lots of hype from the reality of the situation. And that means you’ll need real knowledge about the industry from other sources, not just from the company. Management often engages in “puffery,” trying to move the stock price higher so that they can sell or so the company can issue more stock and keep the business afloat.
Avoid penny stock surcharges
If you’re buying penny stocks, you’re typically buying a huge number of low-priced shares. Some brokers will slap on surcharges for stocks priced below a certain level and charge you even more if you trade more than a certain number of shares.
There’s no reason to tolerate these restrictions. Instead, look for a broker with no surcharges or volume restrictions, and find one that allows you to trade penny stocks just as you would regularly priced stocks. NerdWallet has reviewed and rated the top brokers for penny stock traders, each of which can help keep your trading costs down.