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Penny stocks can be an attractive investment but they come with many risks. Here's how to invest in penny stocks.

Investing is an important part of preparing for your financial future. When you invest money, you’re setting it aside for the future and giving it time to grow. Investments, like stocks, bonds, and real estate can offer higher returns than savings accounts or CDs, but they also come with risk.

Penny stocks are an incredibly risky class of stocks. They are low cost and usually come from small, unknown businesses. Their prices can be highly volatile. Moreover, it can be difficult to buy and sell them because so few of each company’s shares trade on the open market.

Despite their high risks, some enjoy investing in or trading penny stocks. Just as there’s always a chance that the company will fail and you’ll lose all of your investment, there’s the possibility that the company will grow into a major player in its industry. If that happens, your investment can grow by huge amounts.

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What is a Penny Stock?

According to the SEC, penny stocks include any small company with shares that trade at $5 or less. The term penny stock comes from the original definition of shares that trade for less than $1 (meaning you can buy one share with pennies).

Most stock trading happens on major stock exchanges, like the New York Stock Exchange. However, each exchange has different requirements for a company’s shares to get listed on the exchange. Generally, these requirements exclude penny stocks, which means that most penny stock trading happens in over-the-counter transactions.

Because penny stocks aren’t listed on major stock exchanges, they tend to experience low liquidity. Where millions of shares in major companies like Coca-Cola or Amazon might change hands each day, penny stocks often see fewer than dozens or hundreds of shares move daily.

Because penny stocks lack liquidity, it can be difficult to determine a fair price for the shares. Frequently, there is a large bid-ask spread (the difference between the highest offer to buy shares and the lowest offer to sell) for penny stocks.

Low liquidity can also make it difficult for people with shares to sell them quickly, or at all. If no one wants to buy, that means there’s no way to sell.

Because of the risks involved in penny stocks, the SEC regulates them heavily. Brokers who facilitate stock trades have to approve each transaction for the customer, which usually requires a phone call to discuss the transaction and a disclosure of the risks of investing in penny stocks.

Why Do People Invest in Penny Stocks?

People invest in penny stocks for a variety of reasons.

One is that penny stocks are cheap, which makes them accessible to almost anyone with a brokerage account. If you want to buy shares in Amazon, you need to save up the roughly $3,200 that a share costs (as of July 2020). That’s a large amount to most people.

By comparison, you can buy shares in penny stocks for less than a dollar in many cases. That makes it easier to save up the required funds.

However, many see penny stocks as a get-rich-quick scheme. Some people promote certain penny stocks as primed to explode in value. If you can buy one thousand shares of a company at $.10 each ($100 total) and they rise in value to just $2, you’d have made $1,900 in profit. Do that a few times, and you could quickly make huge amounts of money.

The reality is that penny stocks rarely experience such huge gains in value. Many penny stocks ultimately fail, leaving shareholders with nothing to show for the money they put into the shares.

Other people choose to day trade in penny stocks rather than truly investing. Day traders aim to take advantage of the volatility in a company’s shares over the course of a day.

For example, if a business opens at $.50 per share and trades between $.40 and $.60 over the course of the day, a day trader aims to buy shares when they’re closer to $.40 and quickly sell them for closer to $.60, never holding shares overnight.

Day trading is risky because it requires making accurate guesses about the price direction of a stock. Day trading penny stocks adds risk because of their low liquidity.

Finally, people invest in penny stocks because they find them entertaining. Throwing some money into penny stocks, just to see what happens, can be fun, especially for people who enjoy researching companies and their financial prospects. Some choose to dedicate a small portion of their portfolio to unusual or “fun” investments while dedicating the majority of their portfolio to more traditional strategies.

Related: Best Alternative Investments

The Risks of Penny Stocks

There are a few factors that play into the high risk of investing in penny stocks.

Low Liquidity

One of the greatest contributing factors to the risk of penny stocks is their low liquidity.

With shares of major companies, there is an active market of people looking to buy and sell shares. Frequently, a single trading day involves hundreds of thousands or millions of shares in a company moving from one investor to another.

Penny stocks aren’t traded on major exchanges and the companies behind those stocks aren’t household names. That means there are far fewer people looking to buy and sell these shares. In some cases, there will be entire trading days or weeks where no transactions involving a specific company’s shares go through.

This means a few things for investors.

One is that pricing penny stocks is difficult. With frequently traded shares, there is a consensus on the value of the share. When trades happen less frequently, it can be more difficult for the market to come to a consensus and there is frequently a big difference between the highest offer to buy and the lowest offer to sell.

Once you own shares, you’ll probably want to sell them at some point. The low level of liquidity makes that difficult. If there’s no one who wants to buy the shares, you have no one to sell them to. Even if your shares gain value, it can be hard to exit your position before the value drops again because there will be fewer buyers than there are sellers.

Volatility

Penny stocks experience much more volatility than shares of major companies, which can be stressful for investors and lead to losses.

All investing involves risk. There’s a chance you could buy shares in a company that fares poorly and lose some or all of the money that you invested. However, if you buy shares in an established, known business like Johnson and Johnson, Amazon, or Microsoft, you can feel relatively confident that you won’t lose 50%, 60%, or more of your investment in a few hours or overnight.

Penny stocks can experience drastic price swings in short periods. You might buy shares at $.10 each only to find them trading at $.05 each an hour later, $.20 each the next day, and $.01 the day after that.

It can be hard to know when to buy and sell when your portfolio experiences such huge value swings every day or every week.

Difficult to Research

With big companies, it’s relatively easy to do your due diligence and research the business before you invest. Companies have to file reports with the SEC and many publish regular communications to shareholders outlining the business, how it’s faring, and projections for the future.

With penny stocks, it can be much harder to find their SEC filings. It can be hard to research what companies do and the market they operate in. With little information to operate on, it’s hard to know for certain whether a certain stock is a good investment or not.

How to Invest in Penny Stocks

If you’ve decided that you want to try investing in penny stocks, the first thing you’ll need to do is set a budget. Investing in penny stocks is risky, so you want to set a limit for how much you’re willing to invest and potentially lose. Make sure you’re in a stable financial position and have a reasonable emergency fund before you get started.

Research

Once you’ve set your budget, it’s time to do some research. You need to work with a brokerage.

When comparing brokerages, make sure they allow trading of penny stocks. Some brokerages don’t offer trading in penny stocks, while others make it very difficult. If you’re planning to trade penny stocks regularly, you want a broker that makes it easy.

Keep in mind account minimums. If you’re trading penny stocks because you don’t have a huge amount of money to commit to your account, you want to find a brokerage that has no minimum balance requirement to open an account.

You should also look at things like the commissions charged by the broker, as well as other account fees. You want to keep your costs as low as possible to give yourself the best chance to earn a profit.

For example, Zacks Trade charges $.01 per share traded ($1 minimum per transaction). Some brokers don’t charge any commissions at all.

Choose a broker

Once you’ve finished your research on brokers, it’s time to choose one. These are a few of the most popular brokers.

Zacks Trade

Zacks Trade is a low-cost broker that charges a commission of just $.01 per stock included in a transaction (minimum of $1 per transaction). This makes the company a cheap way to trade penny stocks. The company also offers robust trading tools to research stocks and access to dozens of foreign stock exchanges.


TD Ameritrade

TD Ameritrade is a commission-free brokerage for people that want to trade stocks and ETFs that are listed on American exchanges. It offers a lot of educational material and research tools that you can use to learn about the market. The drawback of TD Ameritrade is that it charges a $6.95 fee per transaction for stocks bought and sold over-the-counter, which most penny stocks are. This means you’ll have to be transacting in lots of 700 or so stocks to make TD cheaper than Zacks Trade.


Paladin Registry

If you want some extra guidance, you can also work with a financial advisor who can give you a second opinion on your trades. Companies like Paladin Registry are a good way to find the right advisor for your needs.


Compare Brokerage Accounts

Determine Which Stock to Trade

Once you’ve chosen a brokerage to work with, open an account. Usually, you’ll have to fill out an application and provide some identifying information. You’ll also have to provide your bank info so you can fund the account.

Once that’s done, you should research potential stocks to invest in. Do your due diligence and look for companies that have the potential to grow in the future.

Brokers often offer tools that you can use to research different stocks, such as stock screeners. For example, you can look for companies with specific market capitalizations in certain industries. You can also follow the news to see if any small companies catch your eye.

Begin Trading

After you’ve chosen a stock, it’s time to start trading. Submit an order to buy some shares in the business you want to trade. It’s typically best to submit a limit order, which sets a maximum price you’re willing to pay per share. This can help you avoid overpaying due to the illiquidity common in penny stocks.

There are lots of strategies for choosing when to buy and sell stocks but having an idea of a price target you’ll sell at is a good idea. It can be tempting to hold penny stocks, even after they gain value, but they can be volatile. Sometimes, it’s a good idea to sell and take your profits, even if you miss out on some additional gains. Similarly, selling at a slight loss can sometimes be better than holding shares and hoping they return to their previous value, as they could just as easily become worthless.

Risks

Penny stocks are incredibly risky and it is highly likely you’ll lose money.

Penny stocks are illiquid, meaning that they aren’t traded frequently. You might buy shares, only to find that there’s no one willing to buy them. Even if your shares rise in value, you can’t turn those shares into usable cash unless someone is willing to buy them.

Penny stocks can also be hard to research. With large, public businesses it’s easy to find information in the news or on company websites. Many penny stocks are brand new businesses or so small that almost no one is talking about them. This lack of information makes it hard to accurately value them.

Penny stocks are also incredibly volatile. You need to be able to weather huge spikes and drops in your shares’ value if you want to buy penny stocks.

Bottom Line

Penny stocks are attractive for a number of reasons, especially for new investors. They’re inexpensive and many see them as offering the potential for huge, easy gains.

The reality is that penny stocks are highly risky and volatile. It’s easy to lose a large portion or all of the money that you invest. You can succeed with penny stocks, but it’s best to use them as only a small portion of your portfolio, dedicating most of your money for more traditional, stable investments.

Want More?

Here’s information from the SEC on penny stock rules. And want to know more about day trading – here’s an introduction.

Author Bio

Total Articles: 13
TJ is a Boston-based freelance writer who specializes in credit, credit cards and bank accounts. In his spare time, he enjoys reading, writing, cooking, playing games (of the video and board varieties), soccer, and ultimate frisbee. You can find his work on his website, tjporterwriting.com.

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