Investing in penny stocks may seem like a great idea because of the low initial investment involved in your investment. In short, the main perk of investing in penny stocks is this: They're cheap! They may appeal to investors or traders who don't have a lot of capital to invest or who may be just getting started trading.
Even though they require minimal investment, they also carry significant risks. To help you decide whether penny stocks make sense for your portfolio, we'll walk through a comprehensive definition of penny stocks, whether you can make money with penny stocks, the risks associated with penny stocks, how to choose penny stocks and how to choose the right penny stocks.
By the time you're done reading, you'll have a better idea of whether you want to take on penny stocks as part of your investment strategy.
What Are Penny Stocks?
In order to explain penny stocks, let's first go over the definition of a stock. A stock, often called a "security," represents a unit of ownership of a company. Penny stocks, which are also called “microcap” or “nanocap” stocks, are low-value stocks of smaller companies. The stocks are slightly misnamed because they do not necessarily cost a penny at all. However, they are often priced under $2 per share. The Securities and Exchange Commission (SEC), defines penny stocks as those with a market capitalization of less than $250 million.
Penny stocks are some of the most high-risk securities you can trade because they have a small market capitalization and trade for a relatively low share price.
Where do you find penny stocks? Some penny stocks trade on large exchanges like the New York Stock Exchange (NYSE) or the Nasdaq. However, many penny stocks trade on the over-the-counter (OTC) market or off-trading exchange. This is a decentralized market which means you can trade stocks or other instruments between two parties, without a central exchange or broker. You can access thousands of stocks on the OTC Markets, which are traded on three markets.
Can You Make Money With Penny Stocks?
Yes, it is possible to make money when you trade penny stocks. However, it's important to remember that it is possible to invest in a wide variety of securities and make money. However, it's important to focus on your reasoning behind choosing certain companies —you want to invest in the right companies based on your specific needs.
Risks Associated with Penny Stock Trading
Penny stocks are usually considered high-risk investments due to their low price, high potential for fraud, lack of liquidity, small market capitalization, wide bid-ask spread and high potential for loss.
Risk 1: Penny stocks' lower price could prompt losses.
Penny stocks' low price can be a huge risk. Moving in either direction — a gain or a loss — can happen quickly. For example, let's say a penny stock moves from $1 a share to $1.50, it's an incredible gain. However, it could also go the other way, going from $1 a share to 50 cents per share.
Because of this inherent volatility, penny stocks can be hugely risky. Volatility means that the price of a stock increases or decreases, and higher volatility often equates to higher risk.
Risk 2: Penny stocks could have potential for fraud.
Some penny stocks have been pushed by fraudsters, who have a dormant shell company cover and push pump-and-dump schemes. They buy low-priced penny stocks and spread "news" that the stocks are excellent, then increase the price. These fraudsters typically get rid of their shares and investors end up with worthless shares.
One of the best ways to avoid this issue is to thoroughly investigate the company. Incredible growth can be a red flag because the shell company itself might exist on fairly spindly legs. It's important for investors to research whether the company has been raised from the dead, know where the stock trades — most don't trade on the major exchanges and check into frequent changes of a company's name.
The OTC Markets Group categorizes the stocks into various divisions (based on factors such as company integrity and disclosures) which essentially divides them into higher-quality stocks to lower-quality stocks:
- OTCQX (best tier)
- OTCQB (middle tier)
- OTC Pink (bottom tier)
Risk 3: You'll find a lack of liquidity in penny stocks.
Liquidity means how easy it is for you to transform an asset from stock into cash. Liquidity refers to how easily securities can be sold. You can consider a stock as liquid when you can't sell them without experiencing a loss when you sell. Because many people don't invest in penny stocks, it's tough to unload them, particularly when their price starts to go down.
Risk 4: Penny stocks' small market capitalization can affect your results.
Penny stocks are often considered small cap stocks, which means that they have a small market capitalization. It's a company's share price times the number of shares outstanding. A small market capitalization has a rough capitalization between $300 million and $2 billion.
Ultimately, small-cap companies tend to be riskier investments than larger companies because they don't have the same resources of large-cap companies, which means that small caps are more susceptible to challenges than larger companies.
Risk 5: Penny stocks have a wide bid-ask spread.
The bid-ask spread is the difference between the highest offered purchase price and the lowest offered sales price for a security. The wider the bid-ask spread, the more volatile the stock, which means that the stocks may pinball more quickly compared to stable stocks.
How to Trade Penny Stocks
How do you trade penny stocks? Let's take a quick look at how to trade penny stocks, step by step. Perhaps one of the most important portions of the decision is to do your research before you start trading. Let's take a look.
Step 1: Do your research.
It's important to do wide research before you make a final decision about your decision to trade penny stocks. Most importantly, consider whether these stocks are legitimate prior to investing — one of the worst reasons to choose them is that you get cheap shares.
How does a particular company make money? You can learn a lot by checking out the Securities and Exchange Commission (SEC) website in order to determine whether the company has been delisted from a major exchange. The company's most recent SEC filing will also give you major clues into whether you should invest in a particular penny stock. We'll also walk through a few more factors you should consider before you invest in the next section, such as revenues and fundamentals.
Step 2: Choose a broker.
It's important to choose a broker that matches your preferences and needs. Researching the differences between brokers can help you decide. For example, you may want to compare the charges for penny stock trades from one brokerage account to another because many brokers charge extra for penny stocks. Also, take a look at current incentives.
You may also want to consider the platform available among the brokers you're considering. You likely want to find the best platform that fits your comfort level. For example, if you need a lot of hand-holding, you may want to consider a platform that offers a lot of helpful tools. On the other hand, if you're an experienced trader, you may want to consider a more complicated platform that offers more bells and whistles, including independent third-party research, educational resources and planning tools.
Once you've landed on the right type of brokerage account for you, fill out the new account application, fund the account based on the required minimum investment. Finally, you can get going with your own research.
Step 3: Decide which penny stocks you want to trade.
The OTC Markets website can give you a good idea of which direction you should go, particularly when you consider which investments you want to pull from high- to low-tier investments: OTCQX (best tier), OTCQB (middle tier) and OTC Pink (bottom tier). Choosing from these categories can help you determine how well your trades may pay off.
Step 4: Begin trading.
Consider learning how to trade from your broker's platform. Practicing how to trade using "fake" trading (also known as paper trading) can also help you practice so don't suffer from staggering penny stock losses.
Finally, never invest more than you're willing to lose. You could risk losing some or all of the money you invest in penny stocks.
How to Choose the Right Penny Stocks
When you want to invest in the "right" penny stocks, it's important to take a look at various factors before you hone in on a great penny stock for your portfolio, including the soundness of the business and fundamentals as well as the management of the company.
How does the business operate? Have there been major changes in the business lately, such as an addition to the business or a switch in management? Have the revenues of the company been growing? Furthermore, what are the basic fundamentals of the company and how has the company performed based on hard-and-fast fundamentals?
A few key fundamentals include finding the net sales/earnings before interest, taxes, depreciation and amortization (EBITDA). (You can calculate net income by subtracting all expenses from total revenue and in order to calculate EBITDA, you add the interest and tax line items into the mix as well as the depreciation and amortization.) You can also look into other fundamentals, such as low price-to-earnings ratio and more.
Looking into how the company is managed can give you a bird's eye view of how well the company’s management team manages the company. Gather as much information as possible about the leadership of the company.
There's an argument that says you don't necessarily have to look into "all that" when trading because you're looking for small price movements, but there's value in doing the background work.
Should You Invest in Penny Stocks?
Ultimately, it's up to you whether you think you should go this route. If you're looking for a get-rich-quick scheme, it's important to understand that they are highly speculative investments that can offer a tantalizing image, such as quintupling your money over the course of a few weeks. However, this could be a mirage — in reality, you could be at risk for serious fraud and loss of funds.
What are the alternatives to investing in penny stocks, particularly if you're interested in investing in a small amount of money? You may want to consider investing in fractional shares of stocks instead of penny stocks. Fractional shares mean that you purchase partial shares of larger companies for the same amount that you might spend on penny stocks. That way, you'll invest in more well-respected companies. You can consider using micro-investing apps (such as Acorns) which allow you to invest in fractional shares of these well-regarded companies.
On the other hand, if you do comprehensive research and find that a particular company meets your needs, you may want to give penny stock trading a try.
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