How Do Penny Stocks Work

by | Aug 27, 2018 | BEGINNER |

You’ve probably heard at least one story about an investor making a large profit investing in a penny stock that doubled or tripled in value. They can seem like the perfect bet, assuming you can strike gold buying the right one of them.

What Are Penny Stocks?

The term “penny stock” usually refers to stocks that are priced under $1, although the SEC considers any stock under $5 to be in this category. Investing in penny stocks is risky because there are reasons why they are priced so low. They may be companies that are nearing bankruptcy or have unproven products. Thus, it’s a gamble to guess which one will recover and become more valuable in the future. They’re also low volume, illiquid assets, meaning that it can be hard to sell them to someone else if they don’t turn out to be a good investment.

How Do You Invest in Penny Stocks?

Penny stocks trade like other stocks, though they usually are not listed on major exchanges. The difference with these assets from well-known stocks is their low volume and susceptibility to price manipulation. This makes them riskier to trade because you can wake up to unpleasant surprises. They are also regulated more closely by the SEC to catch investor fraud.

The positive side of penny stocks is that they require a much lower initial investment compared to mainstream stocks. It’s possible to choose a basket of them and make a profit if a couple recover in price. If you’re willing to risk the capital to invest in them, they can pay off.

Things to Know Before Investing in Penny Stocks

Here’s a run down of the risks you’ll need to keep in mind when considering penny stock investments:

– High Risk: These stocks may never recover from the problems that have caused their price to drop below $1. They may go bankrupt and stop trading.

– Low Market Captitalization: These stocks are sometimes called micro-cap because they are low priced and don’t have a large number of shares in circulation.

– Less Information Available: It can be difficult to research these stocks and judge their fundamentals properly. Sometimes you only have market gossip to work with.

– Low Volume: These stocks have been abandoned by most investors, so there’s little interest in trading them. This can cause high price volatility, and it can be difficult to exit a position.

– Price Manipulation: Low volume and high volatility trading makes these stocks targets for price manipulators. Sometimes a stock will be “pumped” with media buzz to make its price rise for a short-term gain.

– Regulators Watch Them: The SEC will sometimes intervene when a penny stock exhibits tell-tale signs of price manipulation. If trading is halted, you may get stuck in a position.

– Lack of History: Some penny stocks are new companies that have yet to prove a product or revenue stream. The market is waiting to see if they’ll establish themselves or fail early on.