The desire to make a quick killing in the stock market draws many inexperienced investors to trade in penny stocks. Unfortunately, this also means many people lose their money in the blink of an eye.
Why would anyone take on this type of risk? As the saying goes, “the higher the risk, the higher the potential returns.” If invested in the right companies, penny stocks can provide enormous returns. So if you’re comfortable with the risk versus return trade-off, and understand that you could lose your money, penny stocks could play a role in your portfolio.
But remember: You could also potentially win a jackpot in Las Vegas.
What is a penny stock and why are they so risky?
A “penny stock” refers to a publicly traded security that has a very low stock price and market capitalization. The Securities and Exchange Commission defines a penny stock as a security that trades below $5 a share. However, stock priced at $7 to $10 might still be considered a penny stock if its market cap is low enough. A company’s market cap is determined by multiplying its stock price by the number of shares outstanding.
Penny stocks are considered to be among the most speculative, high-risk investments you can make for more than a few reasons.
These companies are tiny in size. For example, a penny stock with a market capitalization of $50 million is just a drop of water in the ocean when compared with a large-cap giant such as Johnson & Johnson, which carries a market value just under $300 billion.
Penny stocks could be companies that are brand-new and don’t have any profits from operations. These companies are unproven because of their short operating history and lack of a track record. Large-cap stocks, on the other hand, tend to be companies that have been around for some time, which generate significant profits that can be reinvested in the business for further growth or paid out to shareholders via dividends.
Keep in mind that a penny stock could also be a company approaching bankruptcy. This higher risk of default and uncertainty makes investing in penny stocks extremely speculative.
Penny stocks trade on the Over-the-Counter Bulletin Board exchange or on the Pink Sheets, a daily listing of bid and ask prices for over-the-counter stocks, usually because they are too small to meet exchange-listing requirements. Over-the-counter stocks are often far less regulated than stocks on the New York Stock Exchange or Nasdaq, which means it can be difficult to know all of the details about such a company before you decide to invest.
Penny stocks also tend to be traded very infrequently, making it harder to place a buy or sell order on the stock. The lack of trading activity results in larger bid-ask spreads, which is the difference between the highest price a buyer will pay for the stock and the lowest price a seller will sell it for. This lack of liquidity means you might pay a higher price for the stock than you would like, or you might sell it for much less. In a worst-case scenario, there might be no buyers for your shares after you’ve purchased them.
Since penny stocks are thinly traded and loosely regulated, they are often the target of scammers, stock promoters and manipulators. Investors should be mindful of so-called pump and dump schemes, where scammers purchase shares of a stock, use false or misleading statements to pump up the share price, then sell the stock at an inflated price before its value inevitably collapses.
You should avoid pump and dump scams — they are illegal and victims of such schemes can lose most or all of their investment. The SEC gives these six tips to help you avoid the scam.
If you plan to actively trade penny stocks, keep in mind that some brokerages might charge more for the transactions. Since trading costs will be a bigger concern than if you are a passive investor, take time to find the best broker for penny stock trading who charges the same flat rate — with no additional fees — for any trade, regardless of the stock price.
Why would anyone trade penny stocks?
With all of the potential risks, you might wonder why someone would even bother trading penny stocks. The reason is simple: If you choose the right stock, you can double or triple your money in a very short time. And if you choose a company that grows year after year, and you hold the stock for the long term, there is literally no limit to the gains that can be made.
Although they may be hard to find, some penny stocks are companies that run profitable businesses with the potential for growth. These companies might start as penny stocks, but then grow large enough to become mid-cap or large-cap stocks, leading to tremendous gains for early investors.
Just like any stock you buy, remember to do your due diligence before making an investment decision. This includes reading through income and cash flow statements to see how profitable the company is, checking the balance sheet to compare the company’s assets versus its debts and watching corporate presentations to get a better feel for the company’s product or brand. This will help you spot legitimate companies and weed out obvious scams.
Investing in penny stocks is not for the faint of heart. You should be OK with the possibility of losing 50% to 100% of your investment in a short time. Even if you’re comfortable taking on this kind of risk, it’s still a good idea to carefully research each company and diversify your holdings to better manage risk.