penny stocks

What Are Penny Stocks And How Do They Work?

Penny stocks sound enticing, right? After all, anything that costs a penny is a deal isn’t it? When it comes to stocks, though, that’s not necessarily the case. Yes, penny stocks can be a lucrative investment, but they can also cause you to lose it all if you aren’t careful.

Understanding how the investment works, what you should know before you trade, and what to watch for will help you make the right choices.

What are penny stocks?

In general terms, a penny stock is a stock that trades for less than $5 per share. They generally come from small companies with little capital. They come from companies that are just starting out and need more money, so they turn to the stock exchange to find investors.

You typically won’t find them on the New York Stock Exchange – they are traded as OTC or over-the-counter transactions. You find the quotes and make the trades on the OTC Bulletin Board or through pink sheets, which is an electronic quotation system.

Penny stocks aren’t traded as often as regular stocks, which means there’s less liquidity or willing buyers. Because of the low liquidity, and wide range between the bid ‘price a buyer is willing to pay’ and the ask ‘price the seller is willing to accept’, penny stocks are much riskier than regular stocks especially when you take into consideration the commissions and fees charged by brokers.

How penny stocks work

After the company initially sells its stock to investors, it becomes a registered offering in the secondary market. You may find listings on the New York Stock Exchange and NASDAQ as well as OTC. Because of the complexity of penny stocks, most trade via OTC.

You trade penny stocks via a broker just like you would any other trade. You’ll pay a commission, as you would for any stock trade, as well as a potential extra fee for trading OTC stocks.

Because of the higher risk, it’s important to have a good strategy when trading penny stocks. A stop-loss order should be a part of this strategy. This way if the stock goes in the opposite direction than you planned, you can get out at the price you intended. Your broker will handle the stop-loss order and the immediate sale should that price be reached.

Who should trade penny stocks?

Penny stocks are more volatile than standard stocks, which makes them a risky investment. They should be reserved for investors that have ‘extra’ capital to invest that they can risk. In other words, don’t invest the money you need for retirement in penny stocks – save the money you have to take chances with for this investment.

If you’re a beginner investor, penny stocks may not be the best place to start. Despite their name ‘penny’ making them seem inexpensive, they are much riskier than the more expensive stocks on the stock exchange. Knowing what you’re risking is important before you make a selection.

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The benefits of penny stocks

Even though penny stocks are risky, they do have benefits:

  • The higher volatility means higher rewards when the stocks do well
  • Small companies can get access to the capital they need
  • You don’t need a lot of money to invest in penny stocks
  • There’s no learning curve, if you have the money to risk you can invest in them
  • You can open short sale positions and make money

The disadvantages of penny stocks

  • You typically won’t find nearly as much information about penny stocks as you would regular stocks, making it hard to make an investment decision
  • Most companies offering these stocks are new to the market so there’s no history to watch
  • It’s often hard to sell penny stocks as there’s a much smaller pool of buyers

Watch out for fad stocks

Here’s the problem with penny stocks – they often get ‘hot’ or become a ‘fad.’ You know the stocks – the one everyone talks about, making everyone and their brother want to jump on the bandwagon. Here’s the problem. Once everyone buys the ‘hot’ stock, it’s not so hot anymore. It’s already increased in price as much as it can. The only way to go now is down. With penny stocks, this usually means a drastic drop, aka a large loss.

Rather than following the ‘fads,’ follow what you know. Do your research, buy stocks in industries that you understand and can follow. Following what everyone else is doing will only lead to larger losses and more frustration.

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Penny stocks and fraud

Another area to watch is fraud. Because of the low prices and low trading volume, penny stocks are often prone to fraud. One of the most common methods is the pump and dump. Investors buy a large number of the stocks; hyping it up, making it seem like a ‘great buy,’ result in a ‘fad stock.’ When investors rush in to buy the stock, the investors or fraudulent investors sell their shares or dump them right away. Once the shares are dumped, the market realizes there wasn’t a reason for the increase in price and the share prices fall significantly resulting in a major loss.

Penny stocks can be a great investment if it’s an ‘additional investment’ rather than your main focus. When handled right, this investment can help you make a significant amount of money, but it can also result in a major loss.

Make sure you do your research and work with a reputable broker when trading penny stocks. Don’t let the name fool you into thinking you’re getting a ‘bargain.’ In many cases it’s the exact opposite and you need to be careful or you risk losing your entire investment and then some if you bought on margin.

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We explain how you can make money, save money and grow money.

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Grow money: learn how to invest and trade.

Please note that under no circumstances should any information from this blog be used as replacement for professional financial advice.

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