If you want to invest in stocks but don't want to risk a lot of money, penny stocks let you get started quickly and simply. There are risks with penny stocks, as with any investment, so take care to understand them before you begin.
Since stock market investments are shares of ownership in an underlying company, it pays to look for companies that operate in a way that creates increasing value over time. When those companies do well by increasing revenues, capturing more market share, or growing in size, their share price often follows suit by increasing as well. Success with penny stocks means looking for high-quality companies like these.
If you find a high-quality company still trading at low prices, you can multiply your investment dollars when the shares move higher. But if the price of your pick plummets, the company goes under, or you can't find a buyer when you're ready to sell, that investment sours quickly.
What Are Penny Stocks?
Investing in penny stocks is similar to the process of buying stock in a massive company such as IBM or ExxonMobil. The difference is the share price is much lower and usually much more volatile, and often the company which the penny stock represents is much smaller, newer, or yet undiscovered by other investors.
In the U.S., penny stocks are defined as stock shares that trade for $5 each or less.
They're generally thinly traded, meaning they are traded infrequently and it's difficult to accurately price them, which can also make them difficult to sell.
Sometimes unexpected companies can fit broadly into the penny-stock category. Auto giant Ford Motor Company, for example, was trading below $2 per share after the 2008 financial crisis.
Where Penny Stocks Are Traded
Some low-priced stocks might be traded on the major exchanges, like the New York Stock Exchange (NYSE), NYSE American (formerly the American Stock Exchange), and Nasdaq. However, penny stocks frequently are traded over-the-counter (OTC) in markets such as OTCQX, OTCQB, and OTC Pink.
Quotes for stocks trading in these marketplaces are called "pink sheets" because their listings were once printed on pink paper, though now they're strictly electronic.
Pink sheet stocks are typically penny stocks trading at a low price or stocks from companies that prefer to avoid the financial disclosures required by the major exchanges. The lack of financial data when trading over-the-counter can make it difficult for investors to determine the true value of a stock.
Potential of Scams With Penny Stocks
People who have been burned by scams and those who were fooled into purchasing low-quality companies rightly have bad things to say about penny stocks. The thinly traded nature of most penny stock companies, plus their tiny size in some cases, affords dishonest players the opportunity to try to profit by manipulating stock prices.
People vulnerable to such scams can get taken in by the dishonest hype a scammer gives them about a certain company, perhaps via an online forum or a newsletter. Believing the hype, the investor buys the stock, not knowing that it's worthless.
It is never a good idea to buy a penny stock that has been heavily promoted. No high-quality company needs a promoter to drive its stock price higher. Companies that are worth your investment will increase in size and price on their own.
Ways to Reduce Your Risk
Penny stocks are risky purchases, and investors must take that risk into account when deciding to purchase them. By learning how to research companies and focusing on ones with high-quality operations, you improve your chances of turning a small investment into something much more significant.
Protect yourself by avoiding free stock picks, heavily promoted stock tips, and the less-regulated OTC markets. Find out everything you can about a company's financial position, its operations, and its trading history before buying a share of its stock.
Practice Trading on Paper First
It pays to learn how to invest properly, no matter how long it takes.
Before you begin investing in penny stocks, test out your investing strategy on paper. Keep track of real stock movements with imaginary money investments, and see how you would have done if you had traded actual dollars.
Practice until your imaginary investments are successful. When you're confident in your strategy, then look for good penny stock companies—low-priced companies that are turning the corner and gaining momentum—to buy shares in real dollars. With diligence and research, you'll learn to identify companies whose shares will rise and earn a profit in the process.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.