Are Penny Stocks Legitimate?

All stock are risky, penny stocks more so than others.

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Penny stocks refer to shares sold in small, oftentimes obscure businesses. For the most part, penny stocks trade at under $5 and represent start-up companies that are trying to get off the ground. Penny stocks come in a variety of forms. Some are real businesses that will explode into the mainstream, some are real companies that will fail and some are pure scams. Extensive research that leads to an understanding of the possible risks is crucial before investing in penny stocks.

Buying and Selling

Most penny stocks are not traded on major exchanges. Since penny stocks tend to operate below the midstream, buying and selling them can be difficult and might require an experienced broker. There is much less of a guarantee of finding a buyer or seller at will for shares in penny stocks because the market is smaller. Penny stocks are less liquid than the bigger, better known stocks that are traded on major exchanges.

Legitimate Risks

The simple fact is that most penny stocks fail or don't make any substantial headway. Even penny stocks that represent perfectly legitimate businesses with sound operating models can easily flop. If you are going to invest in penny stocks, be prepared for the very real possibility of losing your whole initial investment. Of course, this is possible for any investment, but it's much easier for a stock to drop from $2 to no value than from $100 to no value.

Possible Rewards

On the other side of the coin, it's a lot easier for a stock to double in value from $2 to $4, than to double from $200 to $400. Penny stocks represent the very real chance of enormous gains that are literally unthinkable for mainstream stock traded on major exchanges. Many major companies start as small cap companies offering penny stocks to raise revenues. If research shows a good business model that you believe in, there is a good possibility for substantial earnings.

Scams and Manipulation

Penny stocks present good opportunities for "scammers" and manipulators and the Internet has only made this more of a possibility. The most common scam is called a "pump and dump," in which a broker who holds substantial shares of the stock hypes up the stock to investors through faulty information, only to sell off all his shares once demand has driven up the price. Good research should be able to guard against this type of scam.

Precautions to Take

As with any investment, the more research you do, the better. Since penny stocks are a favorite arena for scams, some extra homework might be in order. A good first step is to look up the company or contact them directly to verify that they are a real business and to check into what they do. Look up the information that the company has filed with the SEC. The SEC will also provide a statement from independent auditors, which will include their credentials and how they reached their conclusions.