Trading penny stocks

Are you considering penny stocks? Here is what you need to know in today's market.

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Key takeaways

  • Penny stocks are typically issued by small companies and cost less than $5 per share.
  • They can garner interest from some investors who want to get in close to a "ground floor" price.
  • Penny stocks carry greater than normal risks, including lack of transparency, greater probability of loss, and low liquidity.

As the COVID-19 situation has unfolded over the past several months, some investors have sought out companies working on a vaccine or treatments, as well as those that may benefit from the new normal in some other way (think streaming services, telework enablers, virtual workout providers, etc.). In some instances, these opportunities may be lesser known companies—penny stocks, in many cases.

And who wouldn't want to have bought in at ground-floor prices of companies before they became big and successful? That's the hope of many penny stock investors. If you've never heard of penny stocks or are considering investing in them, here are some of the key things to think about.

What are penny stocks?

A penny stock is loosely categorized by the Securities and Exchange Commission as one that trades for less than $5 per share and usually has a relatively small market capitalization (i.e., company value). Fidelity defines a penny stock transaction as a security traded at or below $3.00 and at a quantity over 10,000.

In practice, you might come across several definitions of a penny stock. Some investors consider penny stocks to be those that trade for less than $1 and/or over the counter on the OTC Bulletin Board. You may see penny stocks referred to as micro-cap stocks at Fidelity (or as "small companies" elsewhere).

Investors who like penny stocks perceive them as having several attractive features: the low stock price, which allows investors to buy a relatively large number of shares, and the potential for quick gains." Some penny stock investors may buy tens of thousands of shares for a relatively low amount of money, hoping that the price will rise sharply over a short period of time. But there is much more to think about when it comes to penny stocks.

Prime penny stock risks

It's important to know the risks of penny stocks because of the greater potential for loss associated with these types of investments, compared with established companies that trade on larger exchanges.

In addition to the risks common to all individual stocks, a primary risk of penny stocks is the potential for a lack of reliable, readily available information. In general, penny stocks that trade on the Bulletin Board are not required to disseminate the same type or amount of information as stocks that are listed on big exchanges—like the NYSE.

Also, many penny stocks are issued by newly formed companies with little or no track record. Without enough information, you may not be able to fully evaluate the company.

Quick tip

Because of the unique risks of investing in penny stocks, Fidelity customers can only buy and sell penny stocks by speaking to a representative and acknowledging their understanding of the specific risks associated with trading penny stocks. This is required for those who want to place trades that meet certain criteria. However, you should be extremely careful if you are considering doing so. First consider whether the significant risks associated with trading penny stocks align with your investment objectives, risk constraints, and time horizon. If so, do as much research as possible, considering the fundamentals of the company, the qualifications of management, and the total costs of the purchase or sale, among any other information you can uncover about the company.

Less stringent disclosure requirements can make penny stocks particularly susceptible to illegal "pump-and-dump" schemes where unscrupulous investors buy the stock, actively promote only its virtues (e.g., "pump it up"), and then, if the stock price appreciates, sell it (e.g., "dump") at an artificially inflated price. Because they are often small in size, penny stock companies do not receive the same level of media and analyst coverage as larger, public companies, so it can be difficult for investors to determine the validity of claims made by pump-and-dump schemers. Unfortunately, those who bought the stock at the high end could be left high and dry.

Additionally, penny stocks can have low liquidity. Many penny stocks are thinly traded. When buying or selling a stock that has low trading volume, investors may not be able to do so at their desired price or time, and that can be costly. Low liquidity is a contributing factor to potentially high bid-ask spreads for penny stocks. This means that, relative to most stocks traded on the Nasdaq or the NYSE, the cost of trading these stocks is typically higher.

The lowdown on penny stocks

Of course, there is the potential to make money investing in penny stocks. However, penny stock investors are taking on a dramatic increase in potential price volatility and risk; there is an even stronger chance that investing in penny stocks could result in losing part or all of your investment. The bottom line is this: Investing in penny stocks entails significantly more risk compared with investing in established companies.

Next steps to consider

Find new investing ideas and get up-to-the-minute market data.

Here are 5 steps, plus a range of tools, for active investors to help trade the market.

Here's what the SEC thinks you need to know about penny stocks.

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