What are Penny Stocks?

Penny stocks offer the promise of sensational returns, but they are not without risk. Here’s a look at what are penny stocks and whether they’re worth the hype.

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With penny stocks, the name is very deceiving. Penny stocks don’t actually cost a penny. Instead, they can be anywhere from a penny to $5, based on the Securities & Exchange Commission definition. Other heuristics may consider penny stocks to be anything below $10 or $3 or $1. Whatever the price cutoff, penny stocks are really cheap stocks that typically aren’t traded on major stock exchanges.

Benefits of Buying Penny Stocks

The benefit of investing in a penny stock is that your investment can easily triple or double. Consider if you purchase $1,000 worth of a stock priced at 10 cents and the price increases to 20 cents. Your investment would double and you wouldn’t have to wait long to see it happen. However, there’s also a great risk that you could lose half your investment if that same stock price dropped to 5 cents. You could lose everything if the stock bottomed out or if the company went out of business. There are many success stories, which is why some investors keep putting their money in penny stocks.

Before you purchase a penny stock, your stockbroker is required to give you a document explaining the risk of penny stock investment. Sales fees should also be disclosed. The broker or investment firm is also required to send a monthly statement that shows the current value of your penny stocks. The monthly statement is especially useful because penny stock companies don’t typically file quarterly or annual financial statements as publicly-traded companies do.

Why Penny Stocks Can Be So Risky

Penny stock companies often are not required to file with the SEC, so they’re not as regulated. Not only that, it might be hard to find enough information on the company to decide whether it’s a worthwhile investment. You’ll find few penny stocks on the major stock exchanges, like the Dow or NASDAQ, because they don’t typically meet the minimum standards. Companies may be new, which also means there’s limited information on company performance.

It can be harder to trade penny stocks because it’s harder to judge whether the stocks are worth investing in. So, you may have to offer stocks at a discount to make them more attractive. There is also the potential for liquidity risk if the underlying security is thinly traded.

Investors have to watch out for pump and dump scams, where the scammer hypes up the stock to encourage investors to buy it. The surge in purchases causes the stock price to inflate artificially. That’s when scammers dump their shares and the price subsequently drops, possibly lower than the investor’s original purchase price.

Shell corporations are often the prop behind pump and dump scams. So if you’re looking to buy penny stocks, make sure you investigate the company and look for real business operations.

You should also evaluate the company’s financial statements to determine how healthy the company’s finances look. Check that a reputable firm has audited them and that they’ve filed on time.

Where to Find Penny Stocks

You probably don’t want to invest in a penny stock that you heard about through email, an internet or television ad, or one that you saw on a penny stock trading message board. Many penny stock scams are advertised this way.

You can find many penny stocks listed in the over-the-counter (OTC) market, e.g. Pink Sheets or the Over-the-Counter Bulletin Board. The OTCBB some listing requirements, e.g. that the company be registered with some regulatory body, that requirement isn’t as strict as those from the SEC. However, Pink Sheets doesn’t have any listing requirements. The risk in trading a penny stock is that price information isn’t typically available, so you have to rely on your stockbroker to give you honest price
information.