Penny Stocks: What They Are and How They Work
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What are penny stocks?
Penny stocks — also called microcap stocks — are high-risk shares of companies that have a low market capitalization and trade at a low price. Historically speaking, the term “penny stock” referred to stocks that traded for less than one dollar per share.
The Securities and Exchange Commission has since updated its definition to include any stocks that are traded for less than $5 per share. The definition may vary by broker; as some may put the cap lower, at $3 or $2 a share.
Due to their low cost, penny stock investors will often buy hundreds, or even thousands, of shares at one time. As a result, small fluctuations in the stock price can result in huge gains or losses for investors.
Penny stocks sound great in theory: with unlimited upside potential, penny stocks seem like a low-cost way to quickly grow your portfolio, right? Not necessarily. While there are certainly examples of penny stock investors who became overnight millionaires, home runs in the arena of penny stock trading are few and far between.
Penny stock examples:
Say you had $10,000 to invest and you put it all into a penny stock trading at $0.20 per share, you would effectively own 50,000 shares ($10,000 ÷ $0.20 = 50,000 shares).
A very small price movement in that stock may represent a huge percentage gain – if that stock moves just ten cents to $0.30 per share, you’d have yourself a 50% gain, and your initial investment would now be worth $15,000 (50,000 shares x $0.30 = $15,000). If that same stock ever reached one dollar per share, you would have turned your $10,000 investment into $50,000 with a 500% return on your initial investment.
So why do penny stocks get such a bad reputation? Using the same example above, if the stock moved ten cents in the opposite direction to $0.10 per share, you’re suddenly looking at a 50% loss after minimal price movement.
This is why penny stocks are so dangerous for new investors. While the thought of striking it rich is enticing, penny stock prices are extremely volatile, and those small price movements that can result in big "get rich quick" gains can also represent devastating losses. The world of penny stocks is high-risk, high-reward – but the losses can be huge if share prices don’t move in your favor.
As with most things, when an investment sounds too good to be true, it probably is. It’s easy to see why penny stocks are inexpensive when you look closer at what you’re actually buying. This is not your typical adventure in the realm of purchasing stock. Penny stocks are not inexpensive because you’re getting in on a good deal, but because the companies issuing penny stocks are small and often volatile. In fact, they might even be heading toward bankruptcy or have a past bankruptcy filing.
These companies are typically too small to be quoted on the major stock exchanges. In some cases, they’ve been delisted — pushed off an exchange — for not meeting requirements or maintaining a high enough share price.
» Learn more: How to invest in penny stocks
Why are penny stocks so risky?
Penny stock scams abound
Google “penny stock scams” and you’ll find no shortage of results. Even the websites that tout penny stock trading as a viable investment strategy acknowledge that scams run rampant. Hollywood has even taken notice, as films like "Wolf of Wall Street," or "Boiler Room" are fictional accounts based on real instances of financial firms taking advantage of clients through "pump and dump" schemes involving speculative penny stocks.
The Financial Industry Regulatory Authority and the SEC have issued warnings about penny stocks, specifically about pump and dump schemes. In such schemes, scammers buy shares of what FINRA has referred to as “dormant shell companies with little to no business operations” and then promote the stock as the next hot buy. When the price rises, they sell their shares, causing prices to plummet.
Remaining investors are left with what is in many cases a worthless security.
These days, the promotion may come via email or as a voicemail. Scammers frequently pretend they’re leaving a message with a stock tip for a friend; it appears to be a wrong number, but the mention of the next big winner piques your interest. This goes for any stock, not just penny stocks: If someone tells you a stock is hot, consider the source and do your own research.
Penny stocks are hard to vet
What if you intend to be diligent, and spend countless hours feverishly researching penny stock listings until you find your diamond in the rough? One big difference between penny stocks and regular stocks, according to the Securities and Exchange Commission, is the lack of reliable, accessible information about penny stock companies.
Public companies are required to file regular reports with the SEC, baring the status of their business via audited financial statements. They’re also required to meet minimum standards to be listed on major exchanges, often including a floor for earnings, number of shareholders and the market value of those shares, among other things. And then there is intense scrutiny from stock analysts and researchers, who quickly bring any blemishes in the business into the light of day.
Most penny stocks trade via over-the-counter (OTC) transactions. Stocks listed on the electronic over-the-counter bulletin board (OTCBB) system do not trade on major stock exchanges like the NASDAQ or NYSE. As such, they do not have to meet the same SEC requirements for publicly available information. Even the most dedicated investor may have difficulty finding information on the internal workings of a penny stock company – and the information that is available may not be credible.
Penny stocks can be difficult to sell
If you decide you want to invest in penny stocks, consider this: You don’t make any money on an investment until you sell that investment and realize a gain on the sale. If you buy a stock for $2 and the share price shoots up to $100 — an unlikely short-term scenario — that $98 is no more than a paper gain until you sell the stock and pocket the proceeds.
Penny stocks bring together the dangerous combination of low liquidity and high volatility. They’re often hard to unload, due to all of the above and because the market for these securities is smaller. At the same time, they can be subject to wild and rapid price swings, which means the price could shift dramatically before you find a buyer.
Penny stocks vs. alternatives
If the low price is the main attraction here, you should know there are other investments that are similarly low-cost but come with far less baggage.
Some brokers offer fractional shares, meaning you can buy a fraction of a stock based on a dollar amount you choose, whether that's $5 or $50, instead of paying the price for one whole share.
You can also consider exchange-traded funds. ETFs track an index, such as the S&P 500, and hold shares from the companies in that index. These funds trade like a stock, on an exchange, for a share price, which can be much lower than the typical index fund or mutual fund minimum.
That means you can get instant diversification for a small investment. Depending on the ETF, you could buy in for as little as $20 or $30 a share (though like stocks, some ETFs will be priced higher). That’s more than a single share of a penny stock, sure. But here you’ll get a stake in a basket of listed, regulated companies.
You can also find ETFs at many brokers commission-free, which will save you on the transaction costs that come from a penny stock trade if your broker charges a surcharge for OTC stocks.
» View our picks: The best brokers for ETFs
Do penny stocks ever make money?
Yes, sometimes, but as we said above, they are highly speculative, according to both the SEC and FINRA.
If you are still interested in investing despite the risks, follow a few rules that can help:
Stick with companies that are registered with and regularly report to the SEC.
Research the company and its key officers before you purchase. (Here’s how to research a stock.) Understand the industry, how the company makes money and its chief competitors. FINRA cautions investors to be wary of penny stocks that are newly issued.
Train your eyes for red flags. These include financial statements that haven’t been certified by auditors or that contain unusual loans or other transactions; frequent changes to the company name or business direction; prior SEC suspensions; and an outsize ownership stake in the company by an office or promoter. FINRA also says that if you see a Q as the fifth letter of a stock symbol, that means the company has filed bankruptcy.
Use a reputable broker. A good broker will help you act quickly if you do encounter a scam.
» View our picks: Best brokers for penny stocks
If you are unsure of your commitment to penny stocks and would just like a good all-around broker, also check out our general list of the best online brokers for stock trading.