- Penny stocks, stocks that trade at less than $5 a share, can be lucrative but also dangerous, their market rife with fraud.
- Investors can avoid scams by investing via reputable brokers, avoiding unsolicited offers, and sticking with companies that trade on the major stock exchanges.
- Even legitimate penny stocks are highly risky, so never invest more in them than you can afford to lose.
Novice investors are often lured into penny stocks by their low prices and the promise of enormous gains.
But with low liquidity, limited information, and bad actors, penny stocks are among the riskiest investments around.
Frankly, they're not a good choice for most investors. But if you're looking for a thrilling, high risk/high reward way to invest a small portion of your portfolio, they may be appropriate for you.
What are penny stocks?
Penny stocks are securities that are traded on the cheap. The SEC defines any stock that is less than $5 per share as a penny stock.
They're sometimes called "over the counter" (OTC) stocks (though some do trade on stock exchanges) or referred to by the size of the capitalization of the companies that issue them: "small-cap", "micro-cap" or "nano-cap" stocks.
Why are penny stocks so low-priced?
Mainly because they are low-value. True, some penny stock companies are simply new and have little financial history. But most have fallen on hard times and are simply not worth very much. They are the opposite of blue-chip stocks — those well-established, major corporations that are by-words for slow-but-steady growth.
You can make money investing in penny stocks — but most people don't. They're a little like lottery tickets: You might win a small fortune but the great majority of investors end up losing.
Who should invest in penny stocks?
Penny stocks are for investors looking for a thrill. Or professional speculators.
They're ideal for day traders: people who heavily manage their portfolio and make quick trades to capitalize on small changes in price. If you're an adrenaline junkie, penny stocks could be a satisfying way to invest. The very definition of volatility, when penny stocks move, they move fast.
Penny stocks are risky for several reasons:
- Low liquidity: Penny stocks are thinly traded, which means it can be hard to sell them at the time and price you want. Their lack of liquidity can lead you to get stuck holding a tumbling stock.
- Limited information: Most are traded on OTC exchanges that have fewer rules and regulations — including for filing financial information. The limited information can make it difficult to make careful investment decisions.
- Fraud: "Penny stocks are the Wild West of the financial landscape," says Robert R. Johnson, professor of finance at Creighton University. "Some market participants may conspire to distort prices and trading volumes in order to mislead other market participants."
The pump-and-dump scheme is particularly common. Bad actors trick people into buying shares in a company, only to sell out when the price rises. This leaves other investors with worthless stocks.
How to invest in penny stocks
1. Decide how much you're willing to risk
Most people benefit from a diversified portfolio that limits risk. Penny stocks can be part of one, but it's usually wise to balance them out with cash or super-low-risk investments, like US Treasuries.
Use your "mad money" for penny stocks, not your nest egg.
2. Open an account with a reputable broker
Look for brokers that follow all the SEC's regulations and that provide you with current financial information for any company they recommend. Also, look for brokers that charge an up-front, flat transaction fee/commission, rather than on a per-share basis.
If you're not sure where to start, try one of these best online brokerages for beginners.
3. Look on the larger exchanges
Look for companies listed on bigger stock exchanges, like the New York Stock Exchange (NYSE and the Nasdaq, because they've met these entities' relatively strict requirements for listings — such as shares need to be consistently priced at a minimum of $1 per. Among over-the-counter marketplaces, the OTC Bulletin Board and the OTC Link LLC are also good choices.
The other OTC exchanges, like the OTC-QX, the OTC-QB, and the Pink OTC Markets, have fewer requirements and attract less legitimate companies. Steer clear of them.
4. Do your research
To avoid scams, Asher Rogovy, chief investment officer at Magnifina LLC, emphasizes the importance of thoroughly researching the companies you're interested in. Due diligence is especially vital if you're trading on your own through a platform like Robinhood, which is particularly popular with the penny crowd (it limits its offerings to NYSE and Nasdaq-listed stocks, by the way).
Here's what you're looking for:
- Financial transparency. The company should have publicly available financial reports and a reasonable strategy for growth.
- A solid financial position. Look for companies that have assets and some cash on hand, that are earning money, and that are regularly audited.
- High liquidity. Find stocks that have high trade volumes so you can sell easily. Adam Selita, CEO of the Debt Relief Company notes, "less than a million shares traded daily is a red flag."
5. Critically evaluate your source of info
The most credible information on a company will come from SEC filings — or an analyst report published by a reputable brokerage, investment firm, or independent financial-research firm.
Be skeptical of any unsolicited contact, like cold emails or telemarketing calls. Similarly, don't trust stock picks and recommendations from sponsored content you see published on the web. Selita notes that lots of sponsored content on a certain firm may indicate that insiders are planning on dumping the stock after its price rises.
If the promotional material says "pennies to dollars instantly!"— run.
The financial takeaway
Penny stocks are attractive because they're cheap and may have massive upswings.
But trading penny stocks is more like gambling than investing — most people end up losing. "Penny stocks are the stock market equivalent of betting on a horse with exceptionally long odds," says Johnson. "For practically all investors, speculating in these equities is wholly unsuitable."
That's especially true if you're a beginner or you're trying to steadily grow your retirement nest egg.
Rogovy, too, stresses caution. "It's certainly appealing to think your stock may increase to 10 times its value, but this is exceedingly rare. If an investment seems too good to be true, it probably is."
Still, an investing man does not live by blue chips alone. If you're looking for an alternative to playing the ponies or the lottery — and you can afford to lose whatever sums you invest — penny stocks are an option. Hey, you never know.
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