Penny Stocks: Guide to Penny Stock Trading & Investing

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A penny stock is a share of a small public company that initially trades at a very low price—usually under $5 per share. They’re also referred to as micro-cap stocks, small cap stocks, or OTC stocks. Penny stocks are enticing for some investors because they can be bought cheap and can potentially yield enormous returns.

Penny stocks have been around for as long as the financial industry has existed, but they came into the collective consciousness with the Martin Scorsese film, The Wolf of Wall Street, which depicted the life of penny stock manipulator Jordan Belfort.

The film got a lot of people asking about penny stocks. Are they legal? Can you actually make lots of money by trading them? How do you even go about trading penny stocks?

Let’s answer those questions for you.

What are Penny Stocks?

Tip: If you’re not familiar with stock investing, you should first read our beginner’s guide on investing in stocks.

Penny stocks are priced much lower than other securities. But what else makes a penny stock different than a regular stock? Here are three unique characteristics of penny stocks:

  1. Shares are priced between $.01 and $10 (At SEC.gov, a penny stock is defined as being less than $5)
  2. Penny stocks are issued by small companies that are valued anywhere under $50 million
  3. Penny stocks have poor liquidity—this means that their price can fluctuate dramatically over a short period of time, unlike regular stocks.

On this CNBC market report, you’ll see the stock prices for a few well-established companies (these are not penny stocks).

These are companies that are featured on the NASDAQ-100—the 100 largest non-financial companies trading through NASDAQ. The lowest stock price on this snapshot is $28.51. The other stocks range from $42 to as high as $1,788.

If you scroll further down this list, you’d find a $7 share for Sirius XM Holdings Inc. Although that’s nearly a penny stock price, the company is still valued at over $700 million. You’ll also notice that the stock price has pretty good liquidity—the price has only changed by 0.43% on the trading day.

Penny stocks, on the other hand, can nearly double in value in a very short span of time. Let’s explain how that can be both a good and bad thing.

Penny Stock Trading

When it comes to securities, there’s a difference between “investing” and “trading.”

  • Investing: Investing is for long-term profit—you buy into a company and your profits grow steadily over time as the company grows
  • Trading: Trading is for short-term profit—you buy into a company with the expectation that you’ll get a quick and high return for your shares.

Penny stocks are more associated with trading than investing. Penny stock trading (also known as “pennystocking”) is primarily done for short-term profit: traders buy heaps of penny stocks and wait for the shares to rise dramatically in demand and value. When they do, the traders cash out their shares and reap an extremely high return on their investment.

For example, you might find a penny stock that’s worth $1 per share. You buy 100 shares for a grand total of $100. Suddenly, the stock price leaps up to $10 per share—a 900% increase. You sell all your shares and profit $1,000. That’s a whopping 900% return on investment.

When you invest in penny stocks, you’re investing in a volatile market, which can yield great rewards but also present great risk.

Penny Stock Risks

Tip: Be sure to read our guide on investing mistakes so you’re aware of all risks associated with stock investment.

All investments are risky—there’s no such thing as a “no-risk” investment. However, a penny stock is considered a far riskier investment than other types of securities.

Fraudulent Trading

The main problem with penny stocks is that many of them aren’t listed on the major exchanges. Large exchanges, like the New York Stock Exchange (NYSE) and NASDAQ, require companies to submit financial data to confirm they’re a legitimate business with real value. These reporting requirements are designed to protect shareholders from investing in failing or fraudulent companies.

But a large number of penny stocks aren’t sold on the major exchanges. You’ll find lots of penny stocks on over-the-counter exchanges, or, OTC exchanges. Unlike large stock exchanges, OTC exchanges may not require companies to report financial information, so it’s more difficult to assess whether the company is legitimate.

Here’s a hypothetical example of what could happen with a seedy penny stock on an OTC exchange. A fraudster locates a company that’s new or that’s going bankrupt, or else they might form a fraudulent shell company that sells no real product or service. The fraudster convinces amateur investors to invest in the company—usually with false promises that the company is up-and-coming or has an incredibly innovative product that’s going to take over the market.

“This business is going to be huge!” says the fraudster, “Stock is only fifty cents per share! Buy as much as you can today.”

So, investors buy the stock in droves, which drives up the price to $30 per share. What the fraudster didn’t tell anyone was that he or she had already bought hundreds of shares in the company. Once the stock price hits $30, the fraudster sells his or her shares and makes a huge profit.

But the company’s not going to make profit because it’s failing or fraudulent—so, inevitably, the stock price is going to fall back down to $0.50. If you bought 10 shares at $30 each, then your $300 investment is going to be reduced to just $5.

Even if you bought stock at $0.50 per share, you won’t make money unless you sold your shares when they reached $30. But penny stocks drop very quickly in price, so it’s easy to miss that short profit window.

Since companies that issue penny stock don’t have to report financial data, it can be difficult to tell whether the company is legitimate or not. That’s how Jordan Belfort took advantage of unassuming investors—he convinced them to buy penny stocks for companies with no real earning potential. He didn’t care about helping them make money. He only wanted to create artificial demand so the stock price would increase, and he could cash out his shares.

Not every company that sells penny stocks is failing, bound-to-fail, or fraudulent. Some startup companies just don’t have the capital to pay the high listing fees required by the larger stock exchanges, or they don’t have the minimum valuation. Their only option is to fundraise with low-priced shares.

It’s up to the investor to thoroughly investigate a company and evaluate its future earning potential. But it’s hard to tell if a company is legitimate if it doesn’t have to report its financial information.

Market Timing

What makes it so difficult to invest in penny stocks is that you have to rely on a tactic called market timing. Here’s how market timing works:

  1. You buy stock when the price per share is at its lowest point
  2. You sell the stock when the price per share is at its highest point

The problem with market timing is that it’s near-impossible to predict when stocks will be at their lowest and highest prices. Since penny stocks rise and fall in value so quickly, it’s difficult to tell when it’s the right time to sell—and if you miss the window, you could lose your investment, and then some.

Small Drop, Huge Loss

We’ve assumed that every penny stock is bound to rise far above its original price. But that’s not always true—some penny stocks may only decline in price. Let’s say you bought a share for $3. The price falls by 10% to $2.70—now you’ve lost money. You’ve only lost 30 cents, but if you bought dozens or hundreds of these shares, then you’ll have lost a lot of money.

Higher-priced stocks are able to absorb these price falls much better than penny stocks. That’s because high-priced stocks yield quarterly dividends that are large enough to make up for those occasional price falls.

How to Buy Penny Stocks

Does all this mean that you can’t or shouldn’t invest in penny stocks? Not necessarily. We’re not going to advise you on what stocks you should invest in and which you shouldn’t, but there are things you can do to minimize risk with both regular stocks and penny stocks.

As mentioned earlier, no investment is safe, and there’s always a chance you could lose money. Just like in gambling, never invest more than you’re willing to lose.

Use a Major Stock Exchange

Penny stocks aren’t sold exclusively on OTC exchanges. You can find some penny stocks on major exchanges, too, like NASDAQ. NASDAQ is composed of three trading tiers. The third tier, NASDAQ Capital Market, has penny stock listings that range from $1 to $10.

Companies that list penny stock on NASDAQ Capital Market must report financial information to the exchange. That’s good news for you. When you buy from this exchange, there’s a greater chance you won’t be investing in a fraudulent company.

Don’t Buy Too Many Shares

The less shares you buy, the less money you’ll lose if an investment goes south (this is basically the same rule as “don’t invest more than you’re willing to lose”). When you’re just getting started investing in penny stocks, it may be best to buy a minimal number of shares—or a diverse set of shares—until you get a feel for the market. Unfortunately, you can’t necessarily make a high profit without buying a large number of shares, and that’s why penny stocks are so risky.

Use the Right Tools

How do you locate penny stocks that may be worth buying? Professional penny stock traders use market scanners, which basically just report on the stock prices throughout the day. These scanners enable you to set parameters on stock types, so you’re able to filter out stocks that are greater than $10. Popular market scanners include:

Invest in Companies You Care About

If you’re a new investor, it’s good to invest in companies that are in an industry you’re familiar with or passionate about—it’s a mantra made famous by Warren Buffett.

Think about a topic you’re interested in—maybe you love flying drones. You probably know all the ins and outs about drone-related stuff; you know the difference between a good drone and a bad drone, you know what the current technology is capable of, and you know where the technology is trending. You can use all this information to evaluate a new drone manufacturer and make an educated guess on whether or not they could be profitable.

Use your wisdom and passions to your advantage, and don’t merely buy a stock for its cheap price.

Recap

A penny stock is a stock that’s listed at a very low asking price—usually between $0.01 and $10. Penny stocks are legal to buy, but they’re considered riskier than other types of stocks; companies issuing penny stock may not have to report their financial information on a major stock exchange, and so there’s a greater risk of fraudulent activity behind the stocks. Most investors try to profit from penny stock by timing the market, which is a risky investment strategy. The safest way to invest in penny stocks is to do ample research on the company that’s issuing them, and to only buy stocks that are listed on a major exchange.

Sources

SEC.gov | Investor.gov | CNBC | Forbes |NASDAQ | Investopedia

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