Advertiser Disclosure

Buying Penny Stocks with Low Liquidity

Sept. 15, 2014
Brokers, Investing
Many or all of the products featured here are from our partners who compensate us. This may influence which products we write about and where and how the product appears on a page. However, this does not influence our evaluations. Our opinions are our own.

Penny stocks are an inexpensive but risky option for people who want to trade. Investors who decide to dive into trading penny stocks need to know the particular challenges of dealing with these low-liquidity stocks.

Penny stocks are low-priced common stock of small companies that trade at less than $5 per share, according to the Securities and Exchange Commission. Penny stocks are traded outside major stock markets through either the over-the-counter bulletin board (OTCBB) or in the Pink Sheets, a quotations publication that compiles bid and ask prices of over-the-counter stocks. You can purchase shares of a penny stock through your normal stockbroker even though they aren’t listed on a major exchange. However, your broker may charge an additional fee for these trades.

These kinds of stocks are considered speculative investments and do not have to meet the high standards for listing on major exchanges. OTCBB is registered with the SEC and maintains less strict listing requirements. Pink Sheets, on the other hand, does not file with the SEC and doesn’t enforce any listing requirements. Because of the lower requirements of OTCBB and Pink Sheets, companies that trade on these listings are often going through some type of financial difficulty and may have little to no earnings. Thus, unlike regular stocks, penny stocks do not pay out dividends to shareholders.

Both the danger and appeal of penny stocks lie with their volatility. The “Wild West” nature of penny stock trading is most attractive to those who are willing to risk potentially high losses for the possibility of big profits.  

What is liquidity and why do penny stocks have low liquidity?

Liquidity is the ability to sell an asset quickly without having an effect on its price. Because penny stocks may be less frequently traded, they tend to have low liquidity, which means that it may be more difficult to find a buyer for your shares.

The most important thing to keep in mind when trading penny stocks is not to purchase more than you’re willing to lose. Gambling on penny stocks is tempting because of low prices, but the low-liquidity of these stocks will make it more difficult to sell when you want to at the price you’d like.

How do you manage risk with trading penny stocks with low liquidity?

Regardless of the price of a penny stock, make sure to research a company as much as possible before investing to avoid scams. It’s generally more difficult to find information about these companies, and quoted prices are less likely to be based on the most complete information about them.

This could leave you more vulnerable to scams such as the “pump-and-dump.” The operators of this scheme artificially “pump up” the price of a large amount of cheap stock they own by exaggerating the worth and success of a company. These schemers then reap the benefits of large profits when they sell their stock at a higher price.

The best way you can save money when trading penny stocks is to choose a broker with low or no extra fees. A broker’s terms and conditions will let you know about any trading restrictions, commissions and fees or minimum purchase sizes. It’s also best to find a penny stock that is eligible with the Depository Trust and Clearing Corporation (DTCC). The company handles clearing securities for brokerages. If a penny stock is not DTCC-eligible, you may face extremely high fees and may have even greater difficulty selling your penny stock in the future.

 Stock and money illustration via Shutterstock.