Many investors, including aspiring ones, find penny stocks enticing. The possibility for massive gains is there, allowing you to turn a little bit of cash into a substantial windfall. However, in exchange for that potential comes a ton of risk. Penny stocks are highly volatile, so they aren’t ideal for those with a weak stomach or no tolerance for risk. If you are considering making the leap into penny stocks, here’s what you need to know before you invest.
What Are Penny Stocks?
A stock doesn’t have to cost an actual penny to be considered a penny stock. Instead, depending on how you ask, anything under $5 or $10 a share may qualify. Additionally, the stocks could be on standard listings, like the New York Stock Exchange (NYSE) or NASDAQ. However, that isn’t overly common. Usually, you’ll find them outside of the big markets, such as over-the-counter exchanges.
Just because a penny stock has a low price or isn’t on the NYSE or NASDAQ, that doesn’t automatically make it a bad investment. However, they are usually cheaper for a reason. The company could be struggling, the industry may be new, or demand for the product or service may be questionable. That doesn’t mean it can’t be a success, just that there is a clear barrier, obstacle, or concern impacting the value equation.
The Appeal (and Flaw) of Penny Stocks
The reason penny stocks are attractive is the price point and the profit potential. For example, if you find a stock at $0.50 a share, if it hits a $1, you’ve doubled your money. That makes them seem like good bets.
To many, that seems like a fairly small jump. After all, large companies can see their stock prices swing way more than that in a day, and no one bats an eye.
However, that change represents a 100 percent return. That’s actually massive. The company’s prospects need to shift significantly to generate the required level of interest to spur a price increase of that magnitude.
While it is possible for that to happen, it’s important to understand what that gain actually means. Otherwise, your expectations may not be in line with reality.
Scams Do Exist in the Penny Stock Market
Since most penny stocks are on over-the-counter exchanges, they don’t have to meet the same requirements as those on the NYSE or NASDAQ. Reporting their financials might not be required, and key company information can be missing. As a result, you have the possibility of running into scams.
Both the “pump and dump” and “short and distort” fraud techniques are easier to play out with penny stocks. This is especially true since many penny stock investment decisions are emotionally instead of logical, particularly since information about the companies tends to be limited.
Tips for Investing in Penny Stocks
If you do decide to invest in penny stocks, make sure you use a smart approach. Research the companies thoroughly. Specifically, look for financial filings or statements and, if you don’t find them, consider that a red flag.
Additionally, it’s smart to diversify. Make sure you have some sound, long-term investments in place before you drive into penny stocks. That way, you have some money in lower-risk options, too.
Be vigilant about surcharges. Some brokers charge fees for low-priced stocks or if you trade above a certain number of shares. But there are also options that don’t have surcharges or volume restrictions, so you might want to find one before you hop into the world of penny stocks.
What do you think people should know before investing in penny stocks for the first time? Share them in the comments below.
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