When it comes to finding the next great investment opportunity, many individuals are intrigued by the idea of "penny stocks." The Securities and Exchange Commission (SEC) defines penny stocks as a stock that is valued at under $5 and can often only be traded on peripheral exchanges far-removed from the more popular marketplaces. Although penny stocks attract investors who believe that the "get rich, quick" strategy really can work, it is important to remember that penny stocks remain a highly speculative asset, capable of gaining or losing tremendous value rapidly.
With that in mind, it is important to understand all of the risks and rewards that penny stocks carry before investing seriously in them. Thankfully, however, the relatively cheap nature of these stocks means that you can own a share of these companies with little initial investment.
As the name of the stock implies, you can begin trading penny stocks for very small sums of money. Keep in mind, however, that penny stocks carry their own fair share of risk. Just because your investment is small doesn't mean you won't lose it.
Penny Stock Investing Basics
If you have decided that you would like to invest in a penny stock, there are certain key characteristics you should look for that may provide some insight into the level of risk these stocks carry. Two of the most critical components of a "safe" penny stock (i.e., one that is likely not a scam) are transparency and liquidity.
The term "transparency" refers to the depth of information available to investors about the stock and the company they represent. If, for example, a penny stock is linked to a company with a clearly referenced operating history and a legitimate administrative team, it is more likely that these stocks are legitimate, albeit very inexpensive. However, if a company seems overly opaque (i.e., it is difficult to locate any sort of credible background information), it is quite possible that the stock is part of a larger financial scam designed to cheat opportunistic investors out of their funds.
A lack of liquidity can also be a warning sign for penny stock investors, particularly if your goal is to buy and sell these stocks rapidly. When liquidity is in short supply, it can be difficult to find a buyer for a particular stock. This could prove to be disastrous if the price of a penny stock plummets. High levels of liquidity allow for rapid buying and selling, which can only serve to improve the confidence of investors who may not be fully confident in holding these stocks beyond a matter of days or hours.
Understanding Penny Stock Regulation
Penny stocks often fail to achieve the status needed to be listed on popular exchanges such as the New York Stock Exchange or NASDAQ. This can prove to be problematic to investors, due in large part to the fact that the level of regulatory activity within stock markets drops off tremendously. The "pink sheets," as they are called, host countless penny stocks, which are unable to earn a listing in larger, more reputable exchanges.
Keep in mind that many financial experts consider the listing requirements of the major exchanges to be a gauge of the credibility of the stock in question. For example, if a company cannot offer the 1.1 million shares required by the NASDAQ, this may be a sign that the company is not likely to attract the attention of institutional investors. This, in turn, does not bode well for the longevity of the stock in question.
Moving Forward With Penny Stocks
As with any stock market activity, it is important to acknowledge and understand the risks associated with penny stocks before trading them. There certainly are many stories of investors achieving unbelievable financial returns with these stocks. However, there are an equal, if not larger number of investors who have fallen victim to predatory schemes within this largely unregulated environment and lost most if not all of their investment.
As the name implies, you can begin investing in penny stocks with very small sums of money. However, it is strongly encouraged that you do your own research into each and every penny stock you find before acquiring these shares.
Ryan Cockerham is a nationally recognized author specializing in all things business and finance. His work has served the business, nonprofit and political community. Ryan's work has been featured on PocketSense, Zacks Investment Research, SFGate Home Guides, Bloomberg, HuffPost and more.