Penny Stock Risks to Be Aware Of

The risks of investing in penny stocks are often not worth the potential rewards. While these stocks have a higher chance for return than other investments, they also come with higher risk and lower liquidity. The volatility can be greater and it is harder to predict what will happen next, which can lead to major losses if you’re wrong. Moreover, due diligence is hard when there’s so little information on the company or its stock available online. And while some investors may see this as an opportunity for future profits, others may see it as too high of a risk. So before you invest your money in these highly risky securities make sure that you understand all the risks involved first!

What are penny stocks?

Penny stocks are low-priced and illiquid securities that have little to no information available on them. Most penny stock companies are too small to be listed on major exchanges, like the New York Stock Exchange (NYSE) or NASDAQ; instead they trade over-the-counter (OTC), which means that people can only buy and sell these stocks through brokers and dealers, not directly with other investors. These trades happen on the OTC Quotation System (or “Pink Sheets”), which can be easily manipulated because there is no central exchange or regulatory authority monitoring it. Penny stocks are also often called “fraudulent securities” because of the ease with which they can be swindled. These companies have no real assets or a business and are sometimes just coming out of bankruptcy, but their stock is still “hot” because it has to be traded somewhere.

How to invest in penny stocks

You can invest in penny stocks through most online brokers. However, many brokers have a list of penny stocks that they won’t allow you to trade in. One great place to look for information on stocks is Yahoo Finance ( https://finance.yahoo.com/ ). You can also search other company sites like Google (which owns the stock trading site known as “Google Finance”).

The risks of investing in penny stocks

There are many risks associated with penny stocks that aren’t present in other investments. While some investors see these securities as low-risk, high-reward investments, others see them as overly risky and fraudulent. Some of the risks include:

1. Lack of liquidity

The main risk associated with investing in penny stocks is low liquidity. Liquidity refers to how easily an asset can be traded for cash without affecting its price. For example, a house would have little liquidity because it would be tough to sell quickly and get cash. On the other hand, a large equity mutual fund has high liquidity because its shares can easily be sold for cash. Penny stocks have low liquidity because their volume is often small (there are no clear rules on how many shares must trade in order for there to be “volume,” but trading in a stock that only changes hands once a year has little liquidity). Moreover, the spread between bid and ask prices (the difference in price between what you would have to pay for a security and what you could sell it for) tends to be high compared to other more liquid securities. The lack of liquidity means that investors must often wait longer to turn over their assets and make a profit.

2. Variability in price

Another risk associated with penny stocks is variability in price, which means the security’s value will swing up and down more than other securities or the market as a whole. Because of all the factors that can affect these companies’ values (like lack of information on their company), their stock price can easily rise or fall. This means that someone who buys a penny stock hoping to make a big profit could easily watch their money disappear over the course of months if the company is unable to carry out its business plan properly.

3. Potential fraud

Many penny stocks have no real assets, and are often just coming out of bankruptcy or have no assets, making it additionally hard to tell if the company is doing well. Some scams are so elaborate they make people believe their investment will “make them rich quick” by using slick advertisements and convincing stories but turning out to be completely false. The Securities and Exchange Commission has issued guidance for investors on avoiding potential fraud in penny stocks: http://www.sec.gov/answers/penny.htm (Penny Stock Basics). The SEC has also issued warnings about specific companies (including some that are publicly traded) that they believe to be fraudulent: http://www.sec.gov/investor/alerts/ia_pennies.pdf. However, because of the difficulty in determining if a stock is fraudulent, it’s often best to just be wary and avoid them.

4. Underlying business

Most penny stocks have poor underlying businesses, sometimes with no assets and just a plan to sell more shares in the company to make money. Their business plans are often very risky, which is why investors should avoid them altogether. Investors who chose to invest in companies that don’t have viable business plans or sound financial models often end up losing their money.

5. Lack of information

There is no clear definition for “penny stocks,” but they are generally defined by low prices and small market caps (less than $50 million). Therefore, the information on these companies isn’t as readily accessible as others because there just aren’t enough people interested in looking at them. Since there are often not as many people trading penny stocks, it’s harder to get information about a company (like corporate actions or financial reports).

6. Exchange listing

Many penny stocks are traded on OTC (Over-the-Counter) exchanges, like the OTC Bulletin Board, which is made up of companies that aren’t high-quality businesses.

Strategies for avoiding risk when investing in penny stocks

Because there are many risks associated with investing in penny stocks (like fraud, a poor business plan and so on), investors should look for other low-priced securities that are higher quality. For instance, the price of a stock could be considered “penny” if it is traded at $2 a share or less. However, when choosing companies to invest in, investors should look at the price per share relative to the company’s sales and earnings. For instance, if a penny stock cost $2 billion and had annual corporate revenues of $50 million (that is, it costs 100 times more than its corporate revenue), investors should be wary.

Because there are no clear definitions for penny stocks, however, it can be hard to tell if a stock is worth purchasing (or if it will even be around in a year). One way to determine the “quality” of a stock is to look at its price-to-sales ratio. A higher amount means that investors are willing to pay a higher price for each dollar of sales.

To avoid the risks associated with penny stocks, investors should look for companies that have strong business fundamentals and are listed on major stock exchanges (like NYSE or NASDAQ). Investors can also keep tabs on other publicly traded companies to see how they perform when the economy is doing poorly by looking at the S&P 500 index.