How to invest in penny stocks

What are penny stocks?

Penny stocks are loosely described as stocks that trade below $5 per share. I say loosely because the exact definition is something of a moving target. Some people describe a penny stock as one that trades for less than $3 a share. And others apply the pure definition, referring to stocks that trade for less than $1.

Regardless of where you set the dollar threshold on share prices, penny stocks are cheap stocks.

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Where to invest in penny stocks

If you want to invest in penny stocks, you will need to open up an account with a broker. This is one of the most important decisions you'll make if you want to invest in penny stocks. Because of the risks associated with penny stocks, not all brokerage firms accommodate trading in them.

It's usually straightforward to set up an account. Pick a company, fill out its application form, provide your identifying information like your Social Security number, and fund your account.

Best brokerage firms to trade penny stocks

1. E*TRADE: Trading OTC stocks will cost you $6.95 per trade.
2. TD Ameritrade: You can get penny stocks listed on OTC. The broker charges $6.95 per trade on OTC stocks.
3. Fidelity: Another option to buy penny stocks fee-free.
4. Firstrade: Penny stocks are free to buy and sell.
5. Zacks Trade: ZacksTrade charges 1% of the trade value if the stock price is less than $1 per share; 1¢ per share if the price is more than $1.

Keep costs in mind when deciding on which brokerage to invest with. If you are charged $6.95 per trade, you will have to pay $6.95 to not only buy but also to sell. Keep that in mind when you're looking at penny stocks. Buy a stock for 10¢ a share and sell for 20¢, and you have doubled your investment. But if the broker charges you 5¢ to buy and 5¢ to sell, those fees erase your profits.

But don't completely discount brokers that charge commissions on penny stocks. Since penny stocks are almost certain to be a long-term hold, paying a one-time commission of 1% or $6.95 per trade isn't going to make a significant difference in the performance of the investment.

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Why are they so cheap?

There are two basic reasons a stock might be cheaper and called a penny stock:

1. The issuing company is new or relatively new and doesn't have the kind of track record that generates widespread investor interest.
2. The issuing company's stock no longer holds value due to poor business performance, legal or regulatory challenges, scandals, or any of a dozen other causes.

An investor who buys into the first company hopes to ride the price higher as the company grows. An investor buys stock in distressed companies in the hope of a turnaround or buyout.

In either case, the potential returns can be dramatic, making penny stocks so appealing to many investors. In both cases, you're more of a speculator than an investor. After all, you're not betting on past performance — which is either unknown or known to be poor — but on events that have yet to play out.

Penny stocks can be listed on the NYSE or Nasdaq. But if so, they must meet certain standards for information transparency and have a share price of at least $1. But if a penny stock trades on over-the-counter (OTC), no such standards exist. For this reason, OTC penny stocks are much riskier than those listed on the exchanges. You may also hear OTC referred to as the “Pink Sheets.” Not all stocks traded OTC are penny stocks, but most are.

Why invest in penny stocks?

Reason #1: The single biggest attraction for penny stocks is the potential for super big returns.

For example, a $100 stock that doubles in five years (an average annual gain of 15%) would be considered a good investment. But because of their low prices, some penny stocks double, triple, or quadruple. And some even produce 10-to-1 gains, often in a short amount of time.

Those types of gains are not the norm with penny stocks, but the promise alone is enough to draw in investors.

Further reading: Short selling stocks

Reason #2: The speed of those returns is another attraction.

While you may need to wait years for an established company to double in price, a penny stock can double in under a year and even in a matter of days. Of course, that requires the announcement of an earth-shattering event. Such events include the launch of a new product line, a takeover bid from another company, or the elimination of the negative force that brought the stock price down in the first place.

Penny stocks also appeal to small investors who can buy a large number of shares with just a few hundred dollars.

Reason #3: But perhaps the most significant incentive is to get rich quickly.

Traditional buy-and-hold investing is a long-term commitment, more appropriately described as “get rich slowly.” Some investors, especially small ones who want to get big in a hurry, see penny stocks as the fastest route to get rich.

But it has to be stated categorically that while each of the above is possible theoretically, they're hardly typical. For that reason, invest in penny stocks only with money you can afford to lose.

The risks of investing in penny stocks

Despite the potential for big gains, the risks of investing in penny stocks are more numerous than the benefits.

Some of the risks to consider include:

• Limited liquidity: — One of the reasons the price is so low for penny stocks is because of a lack of interest by buyers. That creates liquidity problems. When you want to sell, there may be no one to buy. That sometimes makes getting out in a hurry nearly impossible.
• Limited information: — If a penny stock trades on the OTC, company information will be extremely limited, if it's available at all. Unlike other stocks, there's no steady flow of reports to base your investment decisions on.
• No exchange-imposed standards: Unless a penny stock is listed on the NYSE or Nasdaq; there's no oversight. The company doesn't have to meet any minimum exchange-imposed standards. This dramatically increases the possibility of fraudulent activity.
• Wide bid/ask spreads: Because of the low liquidity of penny stocks, the bid/ask spread can be uncomfortably large. You may pay $2.50 for a stock that usually sells for $2.00. This gives you an immediate 20% loss on your investment. This gets back to the lack of available buyers. The smaller the pool of buyers, the wider the spread will be.
• The potential for bad news: Due to the low interest in penny stocks, it would take only a few sellers — or one dumping a few thousand shares — to send the price of the stock plummeting. Just because the stock is trading at 90¢ doesn't mean it can't go down to 30¢. And just as the price can go up in a hurry, it can also come down just as fast. That leaves you no time to react and little opportunity to recover after the fact.
• **The company could go out of business:**Penny stocks represent companies that are dangling on the edge of solvency. If the company you're invested in decides to close its doors, your investment — small that it may be — will disappear forever. Some distressed companies never recover, and most small companies never become big companies.
• **Possible schemes:**Keep a lookout for fraudulent deals. Watch out for pump-and-dump schemes, which is when someone claims they have insider information to inflate the price. Sometimes a promoter short sells a penny stock for a high price then gives negative news to lower the price. Also, be wary of any promoter who advises you to buy stock every time the price falls and assures you of massive profits once the price goes up.

How to minimize the risks of penny stock investing

If you're going to invest in penny stocks, you'll need to be fully aware of the risks and ready to do what's necessary to minimize them.

Here's what we recommend

• Have the right mindset going in: Consider all the risks outlined above. Fully understand and appreciate the fact that penny stocks are speculations, not investments. That realization alone should keep you cautious, which is exactly what you need to be.
• Buy penny stocks listed on exchanges: Avoid OTC stocks and stick with those listed on the NYSE and Nasdaq. These companies tend to be of higher quality due to the standards imposed on them by the exchanges. Also, the fact that they want to be on those exchanges indicates a more serious intent about the company's future direction.
• Penny stocks should occupy only a small corner of your investment portfolio: These are not reliable investments and should collectively represent no more than 10% of your total portfolio. The rest of your portfolio should be invested in more stable assets, like mainstream stocks, bonds, cash, and real estate.
• Diversify within your penny stock allocation: Spread your money across ten or more penny stocks. Most will either languish or crash and burn. Only a small percentage will pay off. You'll need to have your money spread across several to take advantage of that possibility.
• Make sure the company has some sort of core value: If it's a distressed company, it should have something positive going for it. These include recognizable trademarks, a valuable product line, or a positive book value (the value of its assets is higher than the market value of its stock). If it's an upstart company, it should have a promising product line with a proven market. The company has to have some element of tangible value, even to be worth considering. And by all means, avoid any company that seems to be mostly promoting a concept.

Should you invest in penny stocks?

It's possible most investors have speculated in penny stocks at some point or at least contemplated the possibility. If you're considering taking the plunge, make sure you're doing it within the context of a comprehensive investment strategy that isn't based primarily on the success of penny stock investing.

You should fully understand the probability that you're going to lose money, all in the hope of getting that big-league home run. And there's a genuine possibility you'll lose your entire investment. It can happen if you choose too many of the wrong companies.

But it can't be emphasized enough: Never invest in penny stocks with money you can't afford to lose. It's best done with “play money,” while most of your portfolio is invested in more traditional and predictable assets.

Finally, if you're seriously considering penny stocks, start by paper trading them. You can paper trade for free using the TD Ameritrade service. Invest real money only if you show a consistent pattern of picking enough winners to make it profitable. If that pattern never emerges, you can give up the effort without having ever lost a penny.

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