Penny stocks are somewhat legendary for turning small investors into wealthy investors, whenever they've managed to ride an investment for a short-term 1,000 percent return. But more often, the volatility and difficulties of trading penny stocks make them risky investments that do not pay off.
Although they're called penny stocks, the Securities and Exchange Commission applies the term to low-capitalized companies trading for $5 a share or less. Many companies, however, do have stock trading for less than a dime. These low prices allow a risk-tolerant investor to load up on a lot of shares at a cheap price, hoping to ride a price rise of a few cents or more for a serious return.
While there are cheap stocks available on the New York Stock Exchange and Nasdaq, many penny stocks are traded on smaller exchanges where reporting requirements and company capitalization thresholds are far less stringent than on the big boards. As a result, changes in company fundamentals or a moderately-sized purchase of a block of penny stock can cause its price to fluctuate wildly. A 10-cent rise is barely noticeable on most stocks, but it can double the value of a penny stock. Meanwhile, a 10-cent drop could wipe out most of the investment.
Riding the Wave
Unlike the companies on larger exchanges, penny stocks may have relatively few investors trading shares at any given time — meaning that even though you may have realized a gain on paper, it may be difficult finding a buyer for your shares when you want to turn them into liquid assets. Investors must also be wary of "pump and dump" scams, in which an unscrupulous investor gets many other people to drive up the value of shares he already holds, then he dumps his stake for a huge profit, the stock price plummets and the other investors are left with a big loss.
Saving Your Pennies
Regardless of the negatives of trading in a penny stock, it is true that some savvy or lucky investors have seen their shares skyrocket in a single day, and exponential returns can be realized in relatively short periods of time. Keep your penny stock investment limited to the capital you're willing to use for high-risk stocks, and be prepared for a total loss or to be stuck with the shares for a while. But when the reward does come, it can be substantial.
Ellis Davidson has been a self-employed Internet and technology consultant, entrepreneur and author since 1993. He has written a book about self-employment for recent college graduates and is a regular contributor to "Macworld" and the TidBITS technology newsletter. He is completing a book on self-employment options during a recession. Davidson holds a Bachelor of Arts in American civilization from the University of Pennsylvania.