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How to Invest in Penny Stocks and Not Get Cheated

Updated on May 25, 2013

Investing in penny stocks is often touted as a great way to make a killing in the stock market. It doesn't take a lot of money, and a small change in the stock price makes investing in penny stocks look like a great idea. It would seem to have some of the volatile swings like commodities trading, but is something the average investor can do. Let's take a look at the pros of investing in penny stocks, along with some of the risks.

Investing in Penny Stocks

Why Invest In Penny Stocks

In the US, a penny stock is defined by the SEC simply to be a common stock whose price is under $5 a share. In general usage, though, most people also think of penny stocks as those stocks that are not only under $5 a share, but are not listed on one of the major stock exchanges, and quotes and trades are handled on the Pink Sheets or over the counter (OTC) on the OTC bulletin board. Generally these are stocks with a small market cap (that is to say the total value of all the common stock is relatively low). For this reason they can also be referred to as small caps, micro caps, or even nano caps.

Many studies whose focus is on value investing have concluded that simply buying the companies with the lowest total market cap and trading them out once a year will outperform the market relatively consistently. There's no doubt that small companies have more room to grow than large companies, so the odds of large percentage gains will be higher.

Low Cost of Entry - Because the price of a common share is low (often under a dollar) it doesn't take a lot of money to buy several hundred or thousand shares, and it just sounds better to own hundreds or thousands of shares than to own say two shares of Google.

Large Percentage Moves - One of the things that sounds attractive is that a small price move for a share price under a dollar translates into a large percentage move. A quarter point more becomes a 25% gain.

Disadvantages of Investing in Penny Stocks

Liquidity - Most of these stocks are thinly traded which leads to a lot of volatility. That means one of the biggest obstacles to investing in penny stocks is that there is not a lot of either dollar volume or share volume being traded in them. Because of this, a relatively small number of shares being traded can cause the price to move, which means that the price will usually move against you if you trade large lots (it will go up when buying and down when selling).

In addition, the market makers will keep a fairly large bid on the stock to protect themselves from this problem which means that even on a stock under a dollar you might see a difference between the price if you are selling versus the price if you are buying of one-quarter or more. This basically means you would have to make 25% on the stock just to break even. This also leads to the major source of fraud that you see in penny stocks, and definitely should not be part of the low risk funds you've set aside for rainy day.

Fraud - Because of the lack of liquidity, a classic stock market technique called "pump and dump" works pretty well. Basically, you buy a position in a thinly traded stock and then you "pump" it. This can be done with spam emails, forum postings, or running a fake advisory service. When the price then rises because of the artificial demand you've created, you sell or "dump" the stock. I've seen one report of a service that purports to be a trading program or robot that is really a front for an operation like this. It's definitely illegal, but some of these are run from outside the US, so they can keep going indefinitely.

Value Investing - While value investing is a time honored way to invest your money, it does require that you have access to some information. The issue is that many of the companies that aren't on the major exchanges don't have to file with the SEC. This means that some companies that are in bad shape, or may not even be a real business, can list on the Pink Sheets and you can't access information on them. And even for those companies who might be the next Microsoft or Cisco, you can't get the information you need to make an informed decision.

Investment Advisory Services - There are a number of advisory services who specialize in investing in penny stocks. As with any advisory service, take a look at their track record, preferably with a 3rd party service like the Hulbert Financial Digest, and see what their total record is. Remember,the real cost of an advisory typically is not the cost of the newsletter, it's the return (or loss) you see on the money you invest based on their advice.

Investing in hot penny stocks is not for the faint of heart, but if you decide to do it, invest wisely. Or you might just be better off cleaning penny stocks out of your portfolio before they clean you out.


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    • drmingle profile image

      drmingle 7 years ago from United States

      I use Hulbert Financial Digest just as you have suggested...

      It has saved me on more than one occassion.

      Great write up.

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    • traderx profile image

      traderx 8 years ago from Las Vegas

      Most penny stocks are scams, in that the price never equates to the value of the business but the public never figures that out - they go by the share price, not the market capitalization.

      I have seen stocks trading at .0002 that have a 20 million market cap, yet they have about 40k in the bank and NO product, and have 1 person working for the company. This is because they issue 10 billion shares, and area always issuing more to pay for everything - all of which is dumped on the market. If you stop to think about it, with 10 bil shares outstanding, for the stock earn even .01 per share they would have to earn $10,000,000 per year AFTER TAXES - good luck right?

    • C. Whitaker profile image

      C. Whitaker 8 years ago from Indianapolis, IN

      You brought up a point I've always wondered about. That is how small companies can omit their financials and other information. So according to this article I guess they only file with the SEC if they want to be listed on a regular exchange, makes sense I suppose. Very good information, you keep it up!