Penny Stocks Are Risky Investments

By Walker England | Updated: November 20, 2019

A Penny’s Worth on Stock

Penny stock trading looks exciting on the surface: invest in new markets and unknown companies, utilize limited capital and receive multi digit returns. While the upside sounds spectacular, the average trader/investor looks at penny stocks through rose colored glasses. The truth of the matter is that penny stock trading can expose traders to considerable risk and provide many pitfalls for the average speculator.

With that in mind, today we will examine some of the basics of penny stock trading.

What is a Penny Stock?

A penny stock is a stock that can be traded very cheaply. One of the misconceptions about penny stocks, however, is that they are always priced at pennies per share. While this has traditionally been true as most penny stocks are listed for under $1, the SEC (Securities and Exchange Commission) considers any stock listed under $5 to be a penny stock.

Penny stocks are also typically traded OTC (over the counter). This means that most are not listed and are not required to meet exchange requirements for listing. Traders should note that penny stocks are usually new businesses. This means that they may not have established track records like traditional Blue Chip companies listed on an exchange like the NYSE (New York Stock Exchange).

What are penny stocks? Why are they so cheap? We explain what penny stocks are and important things to consider prior to investing in them.

What’s the Allure of Penny Stock?

Many new traders are drawn to trading or investing in penny stocks due to their low share price. With BRK-A (Berkshire Hathaway Inc.) trading around $315,000 a share, a stock trading at just $5 a share or less may seem like a deal. Unfortunately, these traders may only be looking at the total number of shares they can purchase while forgetting about the solvency of the company they are investing in.

Image of a penny overlaid with a downward trending stock chart.

The thinking is that if a stock is listed for $1 a share, it only has to go to $2 a share to produce a 100% return. While this statement is true, it can just as easily fall to $0 a share. With this in mind, let’s look at some of the risks of trading in penny stocks.

Penny Stocks Have Low Liquidity

Being able to buy a security is one thing, exiting is another. Unlike major listings on the NASDAQ and NYSE exchanges, penny stocks are considered illiquid. Some penny stocks may only have the equivalent of a few thousand dollars changing hands daily. This can lead to some serious problems. Every buyer needs a seller, and every seller needs a buyer. So, what happens when it’s time to exit your trade and the person wanting to sell is the only person in the world trading that individual security? If there is no counterparty available for the closing transaction, the penny stock trader may just be left holding onto a worthless asset as prices fall.

Penny Stocks Can Be Subject to Market Manipulation

Have you ever received an unsolicited email or seen a web advertisement for an unbelievable investment of a lifetime? Typically these scams are run using penny stocks. The fraudsters in question typically hold a majority stake in an illiquid penny stock. They then attempt to lure new investors to drive up the price in a thinly traded market. As prices drive higher, the fraudster is able to then sell their holdings to the new buyers. Unfortunately, when the buying mania stops, prices fall and most traders are left with staggering losses.

Fundamental Research is Not Available for Penny Stocks

When investing in traditional securities, there is a wealth of information at the trader’s finger tips. However, being on the front line of securities trading through penny stocks comes with many fundamental risks. Penny stocks not listed on major exchanges have little in the way of securities research available. They aren’t covered by major financial networks or analysts. This becomes a problem because a stock may look great on a chart, but be moments away from insolvency. Without any way to determine the fundamentals of a security, there is a risk that the penny stock will become bankrupt or insolvent. Traders need to be aware that this can happen quickly, leaving them with potentially heavy losses.

Penny stock trading may seem exciting on the surface. The promises of quick returns on small investments may be enough to entice even the most seasoned trader. However, this excitement comes with considerable risks. For most, the risk is frankly not worth the reward. If you absolutely must get involved in penny stock trading, it is always best to trade with capital that you can afford to lose.

About the Author
Walker England

Walker England became an active trader just prior to the dot-com bust. This early experience in risk management taught him valuable lessons he shares with his students as an Online Trading Academy Instructor.

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