Trading penny stocks can be a big risk

Are you considering penny stocks? Here is what you need to know.

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Key takeaways

  • Penny stocks are typically issued by small companies and cost less than $5 per share.
  • Risks include lack of transparency and greater probability of loss.
  • High price volatility and low liquidity are other risks.

Who wouldn't want to have bought in at ground-floor prices of companies long 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 features.

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).

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.

A major risk of trading penny stocks can be their low liquidity. Many penny stocks are thinly traded, with far less than a million shares traded each day. 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 New York Stock Exchange (NYSE), the cost of trading these stocks is typically higher.

Venturing into the unknown

More importantly, one of the biggest risks 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.

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, and 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.

The lowdown on penny stocks

Of course, there is the potential to make money investing in penny stocks. For some, penny stocks seem to have several attractive features: the ability to buy a relatively large number of shares due to the low stock price and the potential for quick gains. Some penny stock traders may trade 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.

In exchange for being able to buy a large number of shares—due to a penny stock being relatively low priced—investors in these companies 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: Trading penny stocks can be extremely risky.

Next steps to consider

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

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