What Are Penny Stocks?


If you're looking for big profits from a small investment, then penny stocks may be hard to pass up. These stocks trade at just a few cents per share, which means you potentially can make a nice return from a small investment if the trade works out. The key word here is "if." Penny stocks trade in a murky world outside the regulated environment of the stock exchange. Especially if you're new to penny stock trading, investing in them may be about as strategic as rolling a die.

What Are Penny Stocks?

Penny stocks are stocks that trade at a very low price; not quite a cent, but certainly less than $5 per share. The companies that issue them tend to be small with no trading history and a very small market capitalization. This means that you wouldn't need a huge amount of cash to buy out every single share at the current market price. Penny stocks have a reputation for being a bit of a wild ride – values can rise tenfold or plummet to zero in the space of just a few days. By contrast, gains in the conventional stock market can take many years to materialize. As such, penny stocks are really only suitable for investors who have a high tolerance for risk.

How Do Penny Stocks Work?

Penny stocks trade like any other stock except they don't trade on the major stock exchanges. Rather, they're traded on listing services such as the over-the-counter bulletin board or through the electronic quotation system called "pink sheets." Unlike with regular stocks where you can easily find share prices online, figuring out the price of a penny stock is complicated. Typically, your stockbroker will make a trade based on the bid price – what someone quotes for buying a stock – and the ask price or how much a seller is willing to sell a stock for. The difference between the two is called the "spread" which determines how much money you'll make on a trade.

Why People Invest in Penny Stocks

The main appeal is the potential to generate massive profits by identifying a company that ultimately will become successful. Suppose you invest $1,000 and purchase 5,000 shares of a penny stock priced at $0.20. Even a small rise in value to $1 would give you $5,000 and a $4,000 profit. Since penny stocks are so volatile, these gains could happen in a single day. These types of sudden, big wins generally aren't possible with conventional stock since an investor would need significant amounts of money to buy that quantity of shares.

The Risks of Penny Stocks

Be under no illusion – investing in penny stocks is much riskier than buying an established company's stock. Companies listed on the pink sheets do not have to meet the minimum financial requirements set by the Securities and Exchange Commission to protect investors; many of these companies are either newly formed or they're fire selling stock to ward off a bankruptcy. There's little information on which to base a sound investment decision. Liquidity is an issue, too. Since penny stocks are a niche investment, you might have difficulty selling your shares and have to price them very low to attract a buyer. To protect yourself, it's worth looking for the few penny stocks that are listed on Nasdaq or the American Stock Exchange. These exchanges are heavily regulated and a much safer bet for investors.