You might have heard about penny stocks and thought they sounded like a great deal. Penny stocks, also known as microcap stocks, are cheap — they usually trade for less than $5 per share.
Their low price doesn’t inherently mean they’re bad investments, but penny stocks are usually priced low for a reason. We'll take you through some of the risks, and share steps for how to invest in penny stocks.
» Dive deeper: Read our full explainer on penny stocks
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Penny stock investing
Here’s some practical advice for how to invest in penny stocks.
1. Open a brokerage account
To invest in any kind of individual stock, you'll need a brokerage account, and be particular about which broker you choose.
When you’re buying penny stocks, you’re typically buying a huge number of low-priced shares. Some brokers will slap on surcharges for stocks priced below a certain level and charge you even more if you trade more than a certain number of shares.
There’s no reason to tolerate these restrictions. Instead, look for a broker with no surcharges or volume restrictions, and find one that allows you to trade penny stocks just as you would regularly priced stocks, so you keep your trading costs down.
» Ready to get started? See our picks for the top brokers for penny stock traders
2. Understand you’re probably a speculator, not an investor
If you’re buying penny stocks just because they’re low-priced or you got a “hot tip” from a newsletter or email, you’re a speculator. That means you’re in the stock for a quick “pop,” not to hold it forever. If you get your pop, it’s usually best to sell and move on, because penny stocks often go to zero over time.
In contrast, stock investors tend to buy higher-priced stocks because the companies have been strong performers over time. So investors have the luxury of taking a long-term buy-and-hold approach, because they’re investing for years, even decades, rather than speculating.
» Want to stick with established companies? Learn how to buy stocks
3. Start small and diversify
If you’re going to buy penny stocks, start small and move slowly. Make penny stocks just a fraction of your portfolio, ideally 10% or less of your individual stock holdings until you understand how they operate, what the pitfalls are, and how you can stay safe.
It's also a good rule of thumb to leave most of your nest egg in long-term investments such as a S&P 500 index fund. These funds are easy to buy, and lend the strength of America’s best companies to your portfolio, balancing risks you take with penny stocks.
4. Beware penny stock scams
Penny stocks often reside in the backwater of the market, on the over-the-counter exchanges, not on major exchanges. Outside of the big exchanges, companies don’t have stringent requirements for reporting their financials to investors and may not have to report them at all. Key information is often missing about the company, perhaps even what business it’s in.
Penny stock fraudsters engage in two typical scams. The first is called “pump and dump.” A company or an individual shareholder might hire a promoter to send out emails and newsletters hyping a stock, hoping to push the price higher. The newsletter might make all kinds of promises about the company’s products or future (“the pump”) to get investors excited.
When the stock moves up as a result of the new demand, the individual or company sells a lot of stock at a profit (“the dump”), ultimately causing the stock to fall, according to the SEC.
Then there’s the reverse of that, the “short and distort.” Here, stock promoters “short” the stock — essentially bet that the stock will fall in price — and then try to push the stock lower by writing negative things about the company. This hype may allow short-sellers to make a profit on the declining stock.
» Learn more: What investors need to know about short selling
5. Check the volume
You don't realize any profits until you close your position. If you have a penny stock that soars, but you can’t sell your holdings, that higher price won’t do you any good. Before you buy stock, figure out its average daily trading volume. This number is reported on any good website that tracks stocks.
The higher the daily volume, the easier it generally is to sell. If a stock trades 1,000 shares per day and you own 10,000 shares, it would take on average 10 days to sell it all — if you were the only seller. If the stock spikes, you might not be able to sell in time to get that high price. Stick with modest amounts so that you can sell in a reasonable time frame.
6. Be prepared to research
Most financial advisors would tell you to read the financial filings of any stock you buy, penny or not. You should be able to obtain this information directly from the company, if not from the Securities and Exchange Commission. If there are no financial statements, that’s a huge red flag. Pass on that penny stock and move to another.
When researching penny stocks, you’ll have to disentangle lots of hype from the reality of the situation. And that means you’ll need real knowledge about the industry from other sources, not just from the company. Management sometimes engages in “puffery,” trying to move the stock price higher so that they can sell, or so the company can issue more stock and keep the business afloat.
» Need more info? Learn how to research stocks
Can you get rich off penny stocks?
Technically, you can make money on any stock investment, but there is also the potential for great losses. Penny stocks can be very risky, according to the Securities and Exchange Commission and the Financial Industry Regulatory Authority.
Why are penny stocks risky? They are hard to research, in part because they are not traded on the major stock exchanges, such as the Nasdaq or the New York Stock Exchange. In some cases, penny stock investors are unable to sell stocks back to the dealer they bought the stock from, causing them to lose their entire investment, according to FINRA.
But that doesn’t stop people from trying their hand. The usual argument for buying penny stocks is that a small price increase can turn into a lot of profit. Buy a 30-cent stock and it only needs to go to 60 cents for you to double your money. This reasoning is flawed. While that seems like a small move — the big stocks may move that much or more every day — it represents a 100% return.
A company’s prospects have to change a lot — investors have to expect it to earn much more — for its stock to keep increasing at that rate. A 30-cent move on a penny stock is not the same thing as on a higher-priced stock. And if a stock’s business isn’t very good, it’s even harder for the stock to double.
In addition, sometimes people buy penny stocks because they can purchase more shares. It may make people feel like they’re wealthy to have a thousand or more shares, but your wealth is determined by the total sum invested, not how many shares you have.
If you're looking for a bargain, consider looking at cheap, or undervalued stocks. You can find stocks that are traded on a major exchange, and cost less than $20 per share. These are companies that have a strong foundation in place, and a history of positive performance, but the current stock price may not reflect the growth potential. No investment is without risk, but being traded on public exchanges should make researching the company easier.
» Learn more: Read our guide on finding cheap stocks
Article sources
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- 1.Investor.gov. Pump and Dump Schemes. Accessed Mar 31, 2022.
- 2.SEC.gov. Important Information on Penny Stocks. Accessed Mar 31, 2022.
- 3.FINRA.org. Penny Stock Risk Disclosure Document. Accessed Mar 31, 2022.
