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Updated on Monday, December 17, 2018
The opportunity to purchase stock with a minimal initial investment — or to be an early shareholder in a small company with potentially stratospheric growth — can make the idealistic allure of penny stocks hard to resist. Unfortunately, the reality is often much less glamorous. Penny stocks can be extremely volatile, the underlying companies are often unproven and difficult to value, and they often trade so infrequently that shares can be difficult to sell. This makes penny stocks far more risky than the name implies. And that’s before you factor in the outright fraud that sometimes runs through the penny stock market.
Before you jump in, it’s important you understand exactly how to invest in penny stocks, how they work, and what to look out for if you do. Then strongly consider the risks involved to protect your pocket change from turning into significant losses.
What are penny stocks?
Penny stocks are equities that are low in price — although not necessarily as low as the name implies. The SEC defines a penny stock as trading for less than $5 per share, generally issued by small companies with market capitalizations of $300 million or less. Otherwise known as microcaps (or, if they are less than $50 million, nanocaps), these companies don’t tend to have the established track records or history of public information that more significant, publicly traded companies do, nor do they typically file annual financial statements and regulatory documents with the SEC. For these reasons, shareholders in penny stocks don’t always have the same visibility into the companies in which they invest.
Why the low share prices? Because they generally haven’t been good investments. These may be companies with failing business operations, excess debt or even allegations of fraud. And while it may seem more likely for a company’s share price to increase because it’s only $1, keep in mind that share prices are relative to the company’s value or growth.
How penny stocks are traded
Another thing that makes penny stocks different from other stock investments: they don’t generally trade on stock exchanges like the New York Stock Exchange (NYSE), Nasdaq, etc. Those large, central exchanges have minimum requirements for listing a stock, which penny stocks don’t tend to meet.
Instead, penny stocks often trade over-the-counter (OTC) through online marketplaces where dealers can price and quote securities not listed on a major exchange. Penny stocks are sometimes referred to as OTC stocks or OTC securities.
While there are undoubtedly some skilled traders or professional money managers using penny stock trading as an active investment strategy, the odds are not on the side of the average investor. In 2016, an analyst from the Securities Exchange Commission (SEC) looked at 1.8 million trades made by more than 200,000 individual investors and found that the typical OTC or penny stock investment return is severely negative. It showed that investors were twice as likely to lose money investing in penny stocks as they were to gain and that outcomes were worse when the penny stock was part of a promotion, or it was a less-regulated offering.
Explaining OTC Markets
Two of the most well-known over-the-counter markets are the OTC Bulletin Board and OTC Link Alternative Trading System (ATS). From the investor’s perspective, these trading platforms may not seem different from the NYSE or NASDAQ, but they aren’t the same large, closely watched markets. It’s important to understand which markets are regulated and how.
The OTC Bulletin Board, run by the Financial Industry Regulatory Authority (FINRA), is an online quoting platform for thousands of eligible OTC securities. Companies must meet specific requirements to be included, such as maintaining updated financial reports with the SEC and a getting a broker-dealer sponsorship.
The OTC Link is part of the OTC Markets Group, which is an extensive network of dealers providing online quotes for a broad array of exchange-listed and OTC equities, foreign equities and corporate debt. It does this within three marketplaces, each requiring different levels of filings and information from the companies trading on them.
- QTCQB securities are filed with the SEC or a U.S. bank, thrift or insurance regulator. In other words, they are up-to-date in meeting specific requirements.
- QTCQX securities are either filed with the SEC, U.S. bank, thrift or insurance regulator, or meet alternative requirements, including audited financial statements and a third-party bank or investment advisor to help them stay on top of financials.
- OTC Pink (Pink Open Market) securities are everything else, which may include distressed companies, shell companies, foreign companies uninterested in filing domestically, etc. This is a market for companies that don’t want to file with the SEC.
OTC Link is a member of FINRA and registered with the SEC as a broker-dealer, as well as an alternative trading system.
Buying penny stocks
You can purchase penny stocks through brokers as you would any other type of security, through full-service brokers such as Fidelity and Charles Schwab, as well as online brokers E-Trade, Ally Investments and TD Ameritrade. All have either multiple or extensive trading platforms, reasonably low fees, and provide access to research and education materials.
If you are interested in working with an independent broker, FINRA’s BrokerCheck tool can help you find out if the firm or individual broker is registered.
What to look for in a penny stock
If you are going to purchase penny stocks, research counts; it is arguably more important in the penny stock market, where the companies are small and unfamiliar.
Here are a few key things to look for.
Access to company information
Some companies provide more public information than others, try to favor those that offer the most transparent access to information. Do your research to learn as much as you can about earnings, management, products and services, operations and competition. Analyst research reports are ideal, and a sign of a company worth following. Ask your broker or use their online tools for tracking down any additional information that is available.
You can also search the EDGAR company lookup tool on the SEC website to find the latest company financials. If a company hasn’t registered with the SEC, it might start by filing with state securities regulators in its headquartered state. You can check for those through the company’s Secretary of State or state securities regulator. Any red flags about the company — regulatory actions, past problems with investors, etc. — are likely to surface during this research.
Active trading volume
Trading volume is the number of shares of stock that trade each day. A stock with a higher average daily trading volume and an increasing price may indicate a lot of interest, and the lower the trading volume, the more difficult the stock may be to sell. Low trading volume is also a sign of low liquidity, meaning the stock price may see large swings when investors buy and sell the stock.
The OTC Markets will label certain stocks with a skull and crossbones and as “Caveat Emptor,” or buyer beware. This is to warn investors of shares that may be under suspicion of fraud, a public interest concern or another reason to exercise additional care.
What to avoid when trading penny stocks
You’ve heard of “big fish” stories? Get ready for “big penny” stories, sometimes in newsletters or promotions, sometimes even coming from company leadership.
Beware of claims touting unbelievable returns without risk, and watch out for some of these red flags that the SEC cautions investors about:
When a penny stock investment is promoted heavily through spam email, online newsletters, press releases or cold calling by desperate brokers, it’s generally a sign of a “pump and dump.” That means someone is trying to push the price higher so they can sell shares short and make a lot of money. Even when promotions are not an act of fraud, wise investors should investigate before investing in stocks with wild claims of growth.
If an individual or group within the company owns a majority of the shares, the stock is more at risk for manipulation. According to the SEC, company insiders holding large amounts of the capital can also be a sign of potential “pump and dump” schemes.
The SEC can temporarily suspend trading on the stocks of companies it believes are misleading investors. A stock with a track record of suspensions may be a bad sign.
Big assets, little revenue
Impressive asset numbers may be misleading if the company is including among its assets real estate or other factors not related to the business. Focus on the company’s revenue instead, which will be an important measure of growth.
According to the SEC, microcap fraud often involves strange loans or transactions involving people connected to the company. The footnotes are a great place to look for this type of activity. Additionally, if you’re looking through company financials, check to make sure the auditor has signed off. If not, it’s a red flag.
Penny stocks can be a bit of a roller-coaster ride. The markets are rife with scams, the odds stacked against the average investor — and even if you do get lucky with penny stocks, the investments are generally too risky to build a stable, long-term portfolio.
If you’re still interested in investing in penny stocks, it may be best to get off to a small start and remember not to invest more than you can afford to lose. With a balanced portfolio earning average market returns, a small allocation of penny stocks shouldn’t break the bank.