Penny stocks have an allure for new investors that’s very deceiving. The main reason being thatthe stocks arecheap, and they have the potential for amazing returns; however,they also have the potential to crash and burn, and the latter happens far more frequently than the former. If you’re thinking of investing in penny stocks, an extra dose of caution is necessary.
Penny stocks used to be defined as stocks that traded for $1 or less per share. Over time, however, the SEC has come to define penny stocks as any equity trading below $5 a share. True penny stocks aren’t traded on the major public exchanges; they trade over-the-counter through pink sheets or the OTC Bulletin Board.
This is a very big deal for investors, for a number of reasons. Stocks traded on the exchange must meet stringent listing requirements including market cap, number of shares, and cash flow, and they must meet SEC filing and disclosure requirements. In other words, you have access to a lot of financial information about companies listed on the exchange. There are no such requirements on penny stocks traded OTC. You will have a very difficult time finding the type of credible information you need to make an informed decision about the stock’s value and trajectory.
Penny stocks also suffer from low liquidity. It’s hard to find buyers, which means you may have to discount your shares when you want to unload them, damaging your returns. Low liquidity also leaves penny stocks vulnerable to price manipulation via pump and dump schemes. In pump and dump, stakeholders promote the stock, often by releasing misleading information about the company, in an attempt to drive up the price. As soon as the price inflates enough, the investor dumps them. The unsuspecting buyer is stuck with the inevitable loss.
Short and distort is the reverse of the pump and dump scheme. In this scam, an investor borrows shares and sells them off right away. Then he spreads damaging information about the company and waits for the price to drop. When the price falls enough, he buys up the shares and returns them to the lender to cover his short and pockets a tidy profit.
Now, if you understand the potential pitfalls of penny stocks and still want to proceed with adding them to your portfolio, there are good reasons for doing so. Obviously, a stock with sucha high downside also has the potential for a really huge upside; you can make a lot of money fairly quickly if you pick a winner.
The Golden Rule of investing in penny stocks is only risk money you can afford to lose. Don’t try to fit pennies into your retirement account or other goal-oriented investment. Only use money you haven’t earmarked for something important for investing in penny stocks.
Pay attention to liquidity and trading volumes. If you’ve done your homework and have found a good penny stock, you need to be able to sell your shares when the price is right. Penny stocks are not long-term investments, they are made for short-term trades. If you can’t sell when you need to, you could easily lose your gains in a very short time.
Don’t fall for fads. People promoting penny stocks always call them the next “hot” thing. And by the time you hear about the next hot thing, chances are good the opportunity has already collapsed. Buy what you know, even in the penny stock market.
Look for quality stocks—and yes, you can still find some trading below $5. Although it was never delisted, there was a time during the financial crisis when Citigroup traded for under $1 a share; today it trades at around $65. Obviously, you won’t usually see blue chips trading in penny stock territory, but you can find solid companies in a temporary downturn with a high potential for recovery. Any good stock screener can help you identify prospects.
There is definitely money to be made trading in penny stocks, but you’re more likely to lose your stake than turn a profit. Don’t jump into penny stocks unless you’re willing to do a significant amount of research before taking a position.