Penny stocks are not stocks that cost or return pennies. They are less expensive than other stocks on the market, however. These stocks cost less because they are generally newer to the market and riskier.
You can find good penny stocks, but it might take some work. Learn what makes a good penny stock, how you can find one, and what to avoid.
What Are Penny Stocks?
Penny stocks are shares of small companies that have market capacities of less than $300 million. For this reason, they are also called microcap stocks (if they have less than a $50 million market cap, they are called nano-cap stocks).
Penny stocks can be listed on major exchanges—but many only trade on over-the-counter exchanges. Word-of-mouth marketing and pumping (hyping a certain stock) are commonplace in the penny stock market.
There are several factors to consider when looking for a good penny stock that can keep your principal safe and help you find some microcaps that are worth the trouble.
MicroCap Growth and Trading Volume
Penny stocks should have robust earnings growth that trade close to their 52-week highs. If the stock hasn't been trading for one year, you might want to leave it to other investors.
If you have the capital to burn, and a microcap with no longevity is trending up, you could consider it—but in general, it's best to trade stocks that have time in the market.
It’s essential to also focus on penny stocks that offer a high trading volume—if they're trading over 100,000 shares per trading session, it's likely they are stocks worth investigating.
Penny Stock Prices
Another good rule of thumb is to only trade in penny stocks with a price over $.50 per share. Stocks that sell for less than that price are highly speculative and generally include companies with no discernable track record of success.
Consequently, you should check the company’s financials before buying a penny stock. If there’s documented proof that the company is making a profit and handling its debts well, the odds are lower of losing money on a penny stock purchase.
If they don't publish any financials, you might want to look elsewhere.
Finding a Penny Stock
You can find penny stocks by using a broker's services. Many of the large brokerages offer over-the-counter (OTC) and pink sheet services within their trading accounts. For example, TDAmeritrade provides the ability to enter into trades on penny stocks through their online trading platform.
Once you identify a penny stock that offers potential gains, don’t buy it right away.
Track the stocks you choose for a week or so and monitor how they trade. Look for trade volume, volatile share price swings and determine your best entry price before pulling the trigger on a purchase.
Penny Stock Advertising and Fraud
The microcap market is often used by criminals to solicit funds from unwary investors. They use recent economic trends, natural disasters, or other significant events that can affect finances to target people looking to preserve their capital or generate returns.
It's important to note that penny stock issuers don't generally have the capital to be creating marketing campaigns with flashy media, endorsements from stars, or telemarketing. If you're being contacted about a "good performer", it's likely you're being targeted.
If you are reviewing a penny stock newsletter or similar publication, make sure you read the disclosure notice it should include. This is a mandatory inclusion by the Securities and Exchange Commission (SEC).
Penny stocks are also notorious for having "existing" shareholders present themselves as objective investing experts to "tout” or “talk up” the stock to inflate its price artificially.
Stick to analyzing the company’s financial statements and its history of making money, paying its bills, and being traded by other investors. Those are the key indicators that a penny stock may offer a financial opportunity.
If you cannot find any financial information about a stock or information on the entity that has issued the stocks or media, it is best to file a report with the Financial Regulatory Authority, the SEC, and your state's regulatory authority and leave that particular stock alone.
Facts About Penny Stocks
Here are a few quick facts about penny stocks that might help you decide whether to invest in them or not:
- More penny stocks are traded on an over-the-counter basis (approximately 12,000) than are traded on major exchanges such as the NYSE, NASDAQ, and the American Stock Exchange.
- Penny stocks can trade on other securities exchanges, most notably in foreign stock markets.
- Penny stocks usually represent struggling companies with low cash reserves and no clear path to future success.
- Penny stocks can also be defined as securities owned by private firms, blocked off from public trading.
- Penny stocks don’t usually trade frequently, making them less liquid for owners.
- Penny stocks are highly speculative and are often hard to price accurately.
- The U.S. Securities and Exchange Commission has strict rules on penny stock trading, including written documentation from broker-dealers on the higher relative risk of investing in penny stocks.