Penny Stock Investment Basics

By Stock Research Pro • April 23rd, 2011

A penny stock investment is the purchase of a stock that is trading at under $5 per share (this is the definition the Securities Exchange Commission offers). Another definition says that any stock that trades on the pink sheets or over-the-counter (OTC) would be considered a penny stock. While many investors look exclusively to penny stocks in search of the next great stock investment story, penny stock investing is generally considered to be much riskier than other approaches to stock investing and may not be for everyone.



What Makes Penny Stock Investing so Risky?


A penny stock company is a very small organization with low market capitalization. Often, a penny stock company may be headed for bankruptcy and the low stock price is simply a reflection of this. The risks associated with penny stock investing can include the following:

  • Liquidity- Stocks that are illiquid (not heavily traded) leave the holder at risk for not being able to sell it when they want to. Low levels of liquidity can put the seller in a situation where they need to lower the price until it is deemed attractive to buyers. Additionally, low levels of liquidity make stock price manipulation (e.g. “pump and dump” schemes) more likely.

  • Lack of information-For investors to make informed decisions regarding stock purchases, they need to be able to review detailed information regarding the company, its financial information, and history. Companies that list on the pink sheets are subject to less scrutiny as they do not have a requirement to file with the SEC.

  • Bid/ask spread issues- Brokerage firms that offer penny stocks usually make a profit by building in a markup beyond the price the firm paid to acquire the stock. This fee is not typically disclosed to the buyer and results in spread issues that start the investor off at a loss at the time of purchase.

  • Unreliable recommendations- To drive the price up, many penny stock brokerage firms are known to engage in practices that hype the stock in order to drive up the price. Newsletters, email blasts, and other avenues of communication to would-be investors are often used.


    • Guidelines for Penny Stock Investors


    For anyone who is interested in penny stock investments despite the risks, it is advised that you not risk any more money than you are willing to lose and that (despite the lack of transparency for most of these companies) you learn all you can about company management, financial stability, and prospects for success.

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    The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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