What are penny stocks?

What are penny stocks anyway? You always here about them but does anyone actually invest in them? Well, some do and do quite well. However, it is a very specialized area of investing and should be approached cautiously. Here’s a basic run down of how they work.

Investing in penny stocks is an option many new investors turn to as a way to get into the stock game without a huge upfront investment. By buying penny stocks, the investor can obtain far more shares than they would otherwise be able to with a modest investment. Also, the low prices of these stocks mean that they can double, triple, or more in value quite quickly. Of course, they can lose that amount of value just as quickly. Generally, penny stocks are considered to be higher-risk than larger stocks because of the wild price fluctuations and lower levels of regulation that they must adhere to.

The term ‘penny stock’ is used casually in many different ways, but the basic definition is a stock with a low price that is traded on either the over-the-counter bulletin board (called the OTCBB) or on the pink sheets. For its part, the Securities and Exchange Commission (SEC) classifies any stock trading for less than $5 per share as a penny stock. The most important differentiation between a ‘regular’ stock and a penny stock is where it is traded. Different exchanges have different rules and regulations that apply to them – often, penny stocks end up on the OTCBB or the pink sheets because they can’t meet the regulatory demands of a bigger exchange such as the NASDAQ.

While it is unlikely to see a penny stock used as a long-term investment tool, they are prime real estate for investors looking to make a quick score. As mentioned above, you can see dramatic gains (or losses) in a very short period of time with a penny stock. The following example will illustrate the differences possible between investing in a penny stock and a larger, more established stock.

Imagine that you have $1,000 to invest, and you decide to purchase one stock with all $1,000. You are considering two different options – you can buy 10 shares of a stock that is trading for $100 per share, or you can purchase 1,000 shares of a penny stock trading for a dollar per share. If you choose the penny stock and the price rises $1 per share, you will have doubled your investment. If you buy 10 shares of the larger stock and the price rises by $1 per share, you will have made just $10. This simple example makes the appeal of the penny stock quickly evident.

On the other hand, just as you can double your money quite quickly with a penny stock investment, you can also lose all of your investment in the blink of an eye. While a stock with a $100 per share price isn’t likely to go out of business anytime soon, and $1 stock certainly could. If the larger stock drops by a dollar, you are down $10 and you keep holding the stock waiting for hopeful gains down the road. If the penny stock you purchased drops by a dollar, it is gone and you have lost all $1,000. Penny stocks are inherently risky, and the investor needs to know that going in. That isn’t to say they can never be used wisely, but caution must be taken when making any penny stock investment decision.

The larger trading exchanges like the NASDAQ have very tight regulatory control on the information that must be made available to the trading public. Such regulations do not exist for penny stocks, so quality information from reputable sources can be hard to find. Companies traded on the pink sheets, for example, don’t even have to register with the SEC.

If you are able to find information regarding the financials of these companies, it is important that you check into the sources of that information. Because of the cheap and volatile nature of penny stocks, and the lack of regulatory oversight, scams are far more common than on bigger exchanges. One common trick is for an investor to buy up large amounts of a penny stock and then promote it to others as a great investment. When others jump in, the price rises, and the original investor ‘dumps’ all of their stock for a big profit. The stock price then plummets and the later investors are left holding the bag. You need to ensure that any stock advice you receive regarding penny stocks is legitimate and from an independent and reliable source.

One other issue to consider when investing in penny stocks is liquidity. Liquidity is a term that relates to how fast and easy it is to turn an investment back into cash. A highly-liquid asset is one that can be easily sold whenever you choose. Penny stocks are often low in liquidity because you might have a hard time finding a buyer in the market at the price you want to sell for. When buying large stocks, liquidity just isn’t a problem because there are always enough buyers and sellers. For example, if you own Apple stock and want to sell, there will be willing buyers at all times. However, if you have a penny stock that has increased in value on the exchange and you want to cash in, there might not be a willing buyer to make that deal with you.

A lack of trading volume in penny stocks, and therefore low liquidity, is also a problem because one major buyer can hold powerful sway over the market prices. One large buy or sell order on a penny stock can cause huge swings in the price of the stock and potentially wipe out your investment.

In summary, investing in penny stocks comes with significant risk but also can be quite rewarding if you know what you are doing. The lack of regulatory control and swift swings in price mean penny stocks are inherently more risky than their big brothers. However, that doesn’t mean penny stocks need to be crossed off your list of potential investment avenues. There have been some very solid companies that were once traded among the penny stocks before hitting their stride and moving to a large exchange. The important aspect of penny stock investing, as with any investment, is doing your homework. Not all penny stocks are created equal, so finding the diamond among the rough is the major task and challenge when investing in these smaller markets–but that’s also what make it fun, right?!!

And if you’re not up to the task, at least you can answer someone if they ask you, “What are penny stock, anyway?”