“Penny stocks are cheap but are they a good deal? Yzak/Getty Images
Penny stocks are by definition "worth less" than conventional stocks, but they are not necessarily "worthless." The hardest task for investors is separating the few legit penny stock opportunities from the rubbish heap of failing companies and all-out scams.
Are Penny Stocks Illegal?
Penny stocks are legal, but they are often manipulated. Penny stocks get their name because of their low share price. Any stock trading below $5 a share is generally considered a penny stock. A low share price can mean several things: Maybe it’s a new company that’s just starting out; maybe it’s an established company that’s fallen on hard times; or maybe it’s not a real company at all! The problem with penny stocks is that it’s often hard to tell which of these situations is true.
Investing in a stock means that you’re buying a share of that company’s total value. Stocks traded on the New York Stock Exchange (NYSE) or NASDAQ represent established companies with long track records that are required to file regular financial statements with the Securities and Exchange Commission (SEC). For that reason, it’s easier (although still not "easy" by any means) for investors to predict whether a company’s value is on the rise or in decline.
Penny stocks, on the other hand, are not traded on the big stock exchanges, but rather through "over-the-counter" (OTC) transactions based on prices listed on the Over-The-Counter Bulletin Board (OTCBB) and OTC Link (formerly the Pink Sheets). Companies are often traded on the OTC markets because they can’t meet the strict SEC financial reporting requirements of a larger stock exchange. What that means for investors is that it’s much harder to know the true financial health of a company being traded as a penny stock. Sometimes it’s even hard to figure out what business the company is in!
What to Watch Out for With Penny Stocks
James Royal, an investment writer with Bankrate, worries that new investors are attracted to penny stocks for all the wrong reasons. They see a stock listed for pennies a share and think, "If this stock goes up just one dollar and I own tons of shares, I’d make a fortune!"
"But the reality is, for a penny stock to go up one dollar might require a 300-percent gain," says Royal. "That kind of result is tough enough to achieve when you’re investing in top-notch companies, let alone the poorly run companies in the penny stock world."
Royal says that penny stocks are cheap for a reason. Their market value is so low because investors as a whole have determined that there’s little hope of these companies becoming viable, profitable businesses. That’s not to say that all penny stock companies are doomed to failure. A few might be on the verge of a major turnaround. But to figure that out, smart investors have to do two things: ignore the noise and do their homework.
Making Money With Penny Stocks
First, ignore the noise. The penny stock market is rife with snake oil salesmen promoting the next hot stock tip. There are innumerable online investment newsletters and blogs purporting to pick penny stocks that are about to strike gold. Investors should steer clear of amateur stock analysts. Some are on the company’s payroll, hired to hype the company and raise the stock price. Others are participating in illegal "pump and dump" schemes, in which shareholders make false claims to inflate a company’s share price and then immediately sell off all their shares when the stock spikes.
For accurate information about a company’s current and potential earnings, you’ll need to go to the source. Since few penny stock companies file financial reports with the SEC (you can search for SEC filings), you must call up the companies directly and ask for copies of any and all financial statements. Again, says Royal, not all financial reports are created equal.
"Be careful of overly promotional language promising huge benefits and gains," says Royal. "And be wary of any company that doesn’t want to provide you with its financial statements. That’s a huge red flag."
Interpreting those financial statements and analyzing the company’s position in the larger market is hard work. That’s one of the biggest reasons while Royal and most other financial writers strongly discourage new investors from messing around with penny stocks. Without reliable advice from experienced and neutral stock analysts, you’re largely on your own.
If you’re dead set on giving penny stocks a try, follow these tips from Brian O’Connell at The Balance:
- Avoid penny stocks priced less than 50 cents a share
- Target stocks with high trading volume, at least 100,000 shares per trading session
- Watch and wait — if you’re interested in a stock, track how it performs for a week before buying it. Look for warning signs like high volatility.
- Once you buy a penny stock, don’t hesitate to sell quickly if the price jumps up. Your good fortune likely won’t last long, so cash in before the price drops.
Now That’s Cool
Financial regulators don’t want new investors to fall victim to penny stock scams. In addition to arresting and fining perpetrators "pump and dump" schemes, they provide helpful tips for recognizing when a stock is too good to be true.