A penny stock is one that has inexpensive shares, usually meaning they're trading below $5 per share. Buying stock on margin refers to borrowing money through a stock brokerage to buy the stock. You can work with most stock brokerages to set up a margin account for this kind of trading and then purchase penny stocks as you would buy other stocks, but keep in mind that some brokers will restrict which stocks you can purchase on margin if they see too much risk.
Look for a broker who allows margin trading and set up a margin account with the minimum required deposit for buying on margin. Remember that you must pay interest and can incur more risk through margin stock trading than other trading, and that penny stocks can be quite risky themselves.
How Penny Stocks Work
Penny stocks aren't fundamentally different from other stocks on the market, except that they're inexpensive. Thanks to inflation, the term now usually encompasses stocks selling for up to $5 per share.
Like other shares of stock, they grant a partial ownership stake in a company, usually giving you rights to participate in corporate governance decisions, shareholder meetings and board elections. They also give you the right to collect dividends, or payments to shareholders in proportion to how many shares you own, if the company issues them.
A reason some investors prefer penny stocks is that if you can manage to buy into an up-and-coming business while its stock is still cheap, you can make a handy profit. As with all stock, though, there is a risk you'll lose some or all of your funds, so make sure to do your due diligence and research a company's filings with the Securities and Exchange Commission and other public information before you invest.
Penny Stock Trading Fee Considerations
You can buy and sell penny stocks through a stock brokerage as with any other stock, though some may charge more in fees for trading certain stocks that are less commonly traded or traded off of the main exchanges such as the New York Stock Exchange and the Nasdaq exchange.
In general, brokerage fees have come down thanks to discount online brokers, some of which even offer commission-free trading, but make sure you take into account any fees you have to pay when you're trading as you plot your investments. Since commissions are often fixed regardless of the number of shares of a particular stock you're buying and selling and how much each share costs, you can end up paying a high percentage of your transaction in fees if you're only buying or selling a few shares of a low-priced penny stock.
Shop around for a brokerage that offers a level of fees you like, also taking into account the availability of other features you want like buying and selling on margin, easy access to analyst reports or customer service phone lines. Remember that you can usually move stocks from one brokerage to another if you're not satisfied with the service or fees, and you can also open multiple brokerage accounts across various financial institutions.
Buying on Margin
Buying stock on margin refers to borrowing money through your brokerage to spend on stock. As with other loans, you must pay interest on money you borrow through a margin account, and the rates and terms are regulated by the government and industry self-regulatory groups like the Financial Industry Regulatory Authority, known as FINRA. This means that you'll likely only want to use margin for short-term transactions or ones where you intend to pay off the loan quickly. Of course, as with any investment involving borrowed money, if the stock goes up in value, you can end up making more money than you would have investing only your own cash.
You generally must have a minimum balance in your brokerage account before you can trade on margin, and you must put a minimum amount down using your own funds for such trades. Some brokerages have stricter margin rules than others, so make sure you understand the rates your brokerage charges and the terms of your account. Generally, FINRA requires that you have at least 25 percent equity in your account, with the margin equity definition meaning at least 25 percent of value must be from your money, but many brokers require 30 percent or more. Some brokers may restrict which stocks you can buy using margin.
Also remember that while it's always possible to lose money in the stock market, potentially even losing your entire investment in a stock if the company goes bankrupt, you can actually lose more than you've invested through margin trading. That's because if you borrowed money to buy a stock and it declines in value, you still must pay the balance back on the loan.
This can be especially dangerous with penny stocks, which can sometimes quickly plummet to zero or a very low stock price. You may wish to set stop-loss orders with your brokerage to automatically sell your stock if it falls below a certain value, but keep in mind that some penny stocks are thinly traded and you may not get the price you hope for. Make sure you understand the risks with any investment, particularly one involving borrowed money.
Understanding a Margin Call
If the total value of the stocks and cash in your brokerage account falls, you can risk having too little money relative to the margin loan to satisfy your brokerage's margin equity requirements. This can lead to what's called a margin call, where a broker requires you to make adjustments to your account to get back up above the margin requirements. You can do this by depositing additional cash or even stocks to your account, getting your equity levels back above the cutoff. Alternatively, you could sell some of your securities to pay back the loan, though you may be forced to take a loss if the stock has declined in value.
How a brokerage will notify you of a margin call will depend on the brokerage. If you don't respond in time, the broker may sell some of your securities to boost the level of equity in your account. This can lead to unwanted losses in your account or to unwanted tax consequences, so it's often a situation investors want to avoid.
If you think your shares are declining in value and there's a risk of a margin call, you may preemptively want to sell securities or deposit cash in your account in the way that makes sense for you to avoid your broker handling a margin call for you if you're not available in time.
Penny Stock Fraud Risks
One thing to consider if you're trading penny stocks is the risk of fraud. Because penny stocks are often traded in smaller volumes than more valuable securities, they can be subject to market manipulation by criminals looking to quickly make money.
A somewhat common scenario is the so-called "pump-and-dump" scam, where fraudsters will buy penny stocks without revealing their holdings. Then, they'll publicly promote the stocks using tools like online newsletters and message boards or even telemarketing calls or print newsletters. When other investors buy in, not realizing the conflict of interest, the price will go up due to the small number of shares on the market. Then, with the price effectively pumped up, the scammers will dump their own holdings of the stock, leaving those who bought in to deal with the soon-falling price.
This can be a particular risk if you've bought stock on margin and now must deal with a margin call or debt to your brokerage. Avoid scammers by being wary of stock tips from strangers or dubious sources and doing your own research into any claims about new inventions or developments that could allegedly send a penny stock rising in value.
In recent years, some pump-and-dump scammers have moved to cryptocurrencies and various digital tokens sold through initial coin offerings. These digital currencies and similar financial instruments are often less regulated than the stock market, although regulators like the Securities and Exchange Commission are beginning to step in. They're historically also fairly volatile, meaning that while it can be possible to make money, it can also be possible to lose a fair bit of money quickly. Be especially wary of buying and selling cryptocurrency with borrowed funds due to the volatility, whether this comes from any sort of a margin account or money borrowed through a credit card or personal loan.
Buying Over-the-Counter Stock
Some penny stocks are what are called over-the-counter, or OTC, stocks. That means they're not traded on big exchanges like the New York Stock Exchange or the Nasdaq but through more informal arrangements. In some cases, that's because their low market values don't meet the requirements to be listed on these arrangements.
This doesn't always mean a lot to individual traders, who can often still buy and sell the stocks in usual ways through brokers, but you may not be able to buy these stocks on margin depending on your broker's rules. Make sure you understand which stocks you can and can't trade on margin as you make your investment plans.
As with all stocks, make sure you understand the risks involved with over-the-counter stocks. There's often less information handy about them than their counterparts on the big exchanges.
Margin Interest and Your Taxes
Ordinarily, when you buy stocks or other securities and later sell them at a profit, as you will ordinarily hope to do, that profit is taxable as a capital gain. You can, however, deduct the fees you paid for the securities including commissions, adding it to the effective cost of the stock, called the cost basis. If the stock was bought on margin, you can also often deduct the cost of the interest on the margin loan.
Capital gains tax is also usually lower than your ordinary income rate, paid on income from work, bank interest and various other sources of income. Most taxpayers pay a capital gains rate of 15 percent, while some pay 0 percent or 20 percent depending on their total income.
If you sell stock at a loss, whether to cover a margin call or for any other purpose, you can deduct that loss as a capital loss. These can offset capital gains in the same year or up to $3,000 per year of ordinary income. You can roll an unused capital loss forward to cover additional gains or income in future years according to the same rules, but you can't roll one backward to cover previous income or gains. If you have a penny stock or any other stock and it becomes worthless, you can claim the entire cost basis as your capital loss for tax purposes.
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.