Many investors are lured into to penny stocks because they are cheap, but they have the potential to pay big profits. It’s possible to profit from penny stocks, but it’s not easy. In fact, it’s much easier to lose money on penny stocks. If you do want to take a risk on these stocks, you’ll have a better chance of making money if you understand the game. Here are some things you should know before investing in penny stocks.
Know What You’re Buying
A penny stock is described by the Securities and Exchange Commission as a low-priced (usually under $5), speculative security of a very small company. They can also be called micro-cap stocks, although that term usually refers to the size of the company, whereas penny stocks refer to the actual stock price. Micro-cap stocks include those of companies with a market capitalization of roughly $50 million to $300 million.
Penny stocks are generally traded over-the-counter, but they can also be traded on securities exchanges, including foreign exchanges. Companies that trade stocks over-the-counter are called pink sheets-listed companies. The stocks are usually traded on the over-the-counter bulletin board, or the OTCBB.
Small companies and micro-cap companies generally have less information available to the public and pink sheets-listed companies are not required to file with the SEC. This makes it a lot harder to know what you’re investing in when buying penny stocks. Try to stick to penny stocks with more information, which should be from credible sources.
Let The Buyer Beware
Penny stocks are not subject to the same requirements that are necessary for other stocks. The OTCBB requirements are less stringent than, for example, the New York Stock Exchange. Pink-sheet listed companies are not required to file timely documents with the SEC. Sometimes the reason why a company trades its stocks on the OTCBB is because it failed to meet requirements for some other exchange.
There are, however, some regulations for penny stocks. Before a broker-dealer can sell a penny stock, the SEC requires the firm to first approve the customer for the transaction and receive a written agreement for the transaction. The firm must then provide the customer with a document describing the risks of investing in penny stocks.
Filing quarterly reports and material event disclosures are left to the bigger companies. With less regulation, you should understand that the responsibility to make good investment choices would fall upon the investor.
Avoid Low Volume Stocks
Most penny stocks are illiquid, or have low liquidity. This could make it very difficult for you to sell the stock if you no longer want to hold it. In order to find a buyer, you might have to lower the price until it becomes attractive enough for someone to buy it, leaving you with a loss. To avoid this problem, try to focus on penny sticks with high trading volume. A good point of reference would be around 100,000 trades per day. If a stock is trading at or above that amount, it is likely liquid enough to buy. Stocks that are priced below 50 cents a share are also a sign of low liquidity.
Look Out For Frauds & Scams
Combine the low liquidity with the lack of information and regulation and you have a perfect opportunity for price manipulation, and even fraud.
Since penny stocks are thinly traded and sold at cheap prices, stock promoters and manipulators can buy large amounts of stock, hype it up with positive statements, and then sell it after other investors find it attractive. Manipulators can talk up the stock on newsletter websites, chat rooms, message boards and press releases. Investors would have little information to confirm or disprove these “positive statements.” This price manipulation is also known as a “pump and dump” scheme.
In another sort of scam, companies selling penny stocks pay individuals to recommend the stocks in different media outlets, including newsletters, television and radio shows.
You should take all e-mails, newsletters and other forms of recommendations, especially any from the company itself, with a grain of salt. Take a close look at the person or organization making these recommendations and see whether they may have some sort of motive in making them.
Companies You Should Invest In
While investing and trading penny stocks comes with much risk, there are legitimate companies whose stocks trade at very low prices. A young company just starting out is one example. Buying that company’s stock and holding onto it as it grows can pay off.
Do you research and read all you can (though with a grain of salt) on the company. Look for signs that it is legitimate and growing. Try to find out if the company is making money and how it’s making money. Research the company’s market and product. Avoid companies with a heavy debt load.
Should You Invest?
The best way to make money off of penny stocks is to invest in the right company. Sometimes you can find them by doing your research and knowing what you’re getting into, and sometimes you just need plain luck. The bottom line is that penny stocks are risky and often don’t pay off. If your goal is to invest, rather than gamble, then higher quality stocks would be a better choice.