Investing in Penny Stocks: The Basics, Risks, Pros, and Cons

Penny stocks are a low-cost way of investing. Here’s a look at what penny stocks are, why to buy them, how to pick them, how to trade them, the risks, pros, cons, scams, and the basics to know if they’re right for you.

What are penny stocks and why buy them?

Penny stock is typically defined as shares of small companies that trade for less than $5 per share, according to Investopedia. The reason for purchasing penny stocks is the chance that the value of the stock will grow.

How to trade penny stocks

Some penny stocks are on large exchanges, such as the New York Stock Exchange (NYSE) or the Nasdaq, however, most are traded in the over-the-counter market via the OTC Markets Group (ticker: OTCM), according to US News. There are three tiers of the OTC Markets Group: OTCQX Best Market, OTCQB Venture Market, and Pink Open Market. Purchasing stocks in Pink Open Market: This lower tier of the OTC Markets Group doesn’t have any requirements for financial standards or disclosure. Thus, they can include penny stocks, distressed and delinquent companies, shell companies, and foreign companies with limited US disclosures.

Before purchasing any stock you should research a company’s corporate earnings, profit margins, and the history of the share price. Also, see if there are any company filings with the SEC. However, that’s not always possible with every company listed as a penny stock.

Pros of penny stocks

1. Penny stocks are easy and cheap to buy

You can buy stocks for $5 or less in about a minute. Most brokers will allow you to invest in penny stocks commission-free, according to CalBizJournal.

2. Can offer high reward in short span

Despite their volatility, penny stocks can offer a high reward in a short span, yielding significant profits, according to Educba.

3. High return on small investment

With a low barrier of entry, penny stocks have the potential to return massive profits.

Cons of penny stocks

1. Highly volatile and risky

The prices of penny stocks can go from low to high or vice versa rapidly. If your penny stock has a huge appreciation (for example 1000%), it may be difficult to find a buyer in order to profit from it. Penny stocks are best suited for people with a high tolerance for risk.

2. Difficult to understand financial health of businesses

Because penny stocks do not have to file reports with the U.S. Securities and Exchange Commission, it’s hard to assess a business’s financial health.

3. Lack of history with new companies

Many penny stocks are connected to small, and often new companies, so there is not enough of a track record to look at a company’s financial history and assess its financial stability.

4. Can be difficult to cash out

It can be hard to sell shares because of a lack of available buyers in the market at the time you wish to sell and cash out.

Watching out for penny stock scams

The most notorious scam with penny stocks is the “pump and dump.” A person or a group will artificially drive up the price of penny stock, then sell it after a significant price gain. The new buyer loses as the price immediately plummets after the selloff.

How to pick penny stocks

As a rule, penny stocks are highly speculative, which makes choosing the “right” penny stocks difficult, as there is no tried-and-true method. Again, investing in penny stocks is risky, therefore, it is best for investors with high risk tolerance.

A method some penny stock investors use is simply to look for companies that offer new ideas, new products, or ways for taking something that exists and doing it better. Also, look for companies that seem to have solid performance over time.