How To Invest in Penny Stocks

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Penny stocks are just like any other stocks, but they are different in a few key areas. Trading penny stocks successfully requires a completely different approach than other investments. However, at their core, penny stocks are regular securities that cost less than five dollars.

If you’ve decided to start investing, you’ll need to find a broker. Almost every broker allows users to trade some penny stocks, but you will need to find a broker that offers OTC stock trading if you really want to get in the game.

Looking for this month’s top penny stock picks? You can find them on this page.

Finding a Broker

Millions of retail traders use zero-commission brokers like Robinhood and WeBull, but many of these budget brokers don’t offer access to OTC stocks. Despite the limitation, investors can still trade lots of exchange-listed cheap stocks. However, if you really want to dive into the penny stock game, you’re going to need a broker that offers OTC trading.

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Charles Schwab Now Offers Zero-Commission Trading

Luckily, most major brokers dropped their trading commissions in 2019. Now, you don’t have to pay $5 to trade with a big-name broker. Schwab, E*Trade, and TD-Ameritrade now offer zero-commission trades. Traders can access a vast array of investment options with any of these brokers, including OTC stocks.

More Cheap Stocks

If you’re interested in trading cheap stocks but want something a little more stable, be sure to check out the top stocks under 10 dollars. Find this month’s top picks here.

What Are OTC Stocks?

Over-the-counter (OTC) stocks aren’t listed on major exchanges. Instead, OTC stocks trade via a broker-dealer network. The dealers use the Pink Sheets listing and OTC Bulletin Board to make the market.

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Pink OTC Markets Have Become More Popular Then OTCBB in Recent Years

The key thing to remember about OTC stocks is that trading is facilitated by dealers, not a public exchange. Dealers set the prices for these securities.

OTC Bulletin Board (OTCBB) is an electronic listing service. It’s operated by the Financial Industry Regulatory Authority, aka FINRA, and it’s free for subscribing members. OTCBB used to be a popular forum for trading OTC stocks, but these days it’s on the decline. Pink Sheets is taking the lead in OTC trading.

Pink Sheets operator OTC Market Group offers three listing classes: OTC Pink, OTCQB, and OTCQX. OTCQX is more tightly regulated than other types of listings and companies need to meet certain requirements to make the grade, so companies listed on the QX are higher quality investments than other OTC options. Outside of the OTCQX, the OTC market is pretty much a free-for-all. Practically any company can list its shares, as long as they have enough money to pay for it.

Reasons for Listing OTC

Companies choose OTC listings for a variety of reasons, but most of them are financial. NYSE and NASDAQ require companies to meet strict financial and governance standards before they can list shares. This can be a significant burden for smaller companies, companies with low levels of cash, and foreign firms. Instead, many choose to forego major exchanges to list OTC. However, successful companies don’t stay there for long. Most successful companies eventually transition to major exchanges.

OTC Penny Stocks

When you access the OTC markets, you’re opening up a whole new universe. Traders can access thousands of stocks that aren’t available via traditional exchanges. Many of these companies are small and obscure, however, so most OTC penny stocks ARE NOT suitable investments for most traders. If you’re going to trade OTC stocks, make sure you do your due diligence and fully understand the risks.

day trading for dummies
Trading Penny Stocks Can Be Stressful. If You’re Investments Are Stressing You Out, You’re Risking Too Much. Always Err On the Side of Caution

Pros and Cons of Penny Stocks

In this case, higher risk translates to greater potential for reward. Picking winning penny stocks can net truly massive gains. Traders who buy successful companies early are in for a long, profitable ride to the top. Can you imagine buying Amazon (AMZN) in 1997 what it was trading for $1.31 per share? Penny stocks trading offers the potential for truly amazing rewards, but this is obviously an extreme example. Unfortunately, picking winners isn’t easy and many penny stocks eventually go to zero. If you’re a long-term investor, penny stocks aren’t usually the best option.

Conversely, volatility in penny stocks gives short-term traders plenty of opportunities to turn a profit. These stocks often trade erratically, and they’re so cheap that traders can leverager smaller moves into larger profits. That’s why day traders love penny stocks, they don’t care if the stocks they buy eventually go to zero because they don’t hold stocks overnight. If they catch a pop, they’ll be long gone before share prices come back down.

Pros

  • Affordable. A round lot of shares cost no more than $500, so even small-budget retail traders can afford to buy round lots.
  • High Reward Potential. Traders that manage to pick long-term winners can net huge profits over time. In the short term, penny stocks go up very quickly if they start to attract hype.
  • Volatile. These stocks tend to make large moves, so they’re great for day traders and swing traders.

Conversely, there are a number of downsides associated with penny stocks. First and foremost, they’re risky. That’s a fact that can not be emphasized enough. You have to be very careful when trading stocks this cheap, especially if you’re considering the OTC market. Many of these companies won’t survive long enough to grow into maturity.

Be very careful when trading OTC stocks. OTC listings are lightly regulated so they attract scammers. Shady firms form shell companies with no value, list them OTC, pump up the price with misleading marketing or outright lies, and then cash out their shares. These types of scams, ‘Pump and Dumps’, occur regularly so traders really need to be cautious when considering OTC investments. Always, Always, ALL-WAYS; do your due diligence! 

If you’re shopping for long-term investments, steer clear of penny stocks. Most of them aren’t suitable for the average investor. For every success story, like Amazon or Netflix (NFLX), there are thousands of losers that go to zero. Stocks go to zero every day. Failed companies outnumber successful ones by a large margin. These are not the kinds of stocks you buy for your 401(k) or IRA, penny stocks are best suited to short-term, stick-and-move trades.

Cons

  • Barriers to Entry. Many penny stocks are OTC stocks, so you’ll need to use a broker that offers OTC trading.
  • Very High Risk. Trading penny stocks is not for the faint of heart or weak of wallet. These stocks can exhibit huge downward gaps when they get bad news, so stop-losses won’t always save you.
  • Bad Investments. You have a better chance of winning the lottery than picking the next Amazon. Many cheap stocks eventually go to zero.

If you’re searching for investments with fewer risks, you should check out our article on the best gold stocks.

Closing Thoughts

People that are new to trading love penny stocks because they’re so cheap, but new traders should be careful. It’s a challenge predicting which way these stocks will go. Make sure you have a plan before entering a trade and stick to your strategy. Don’t let stop-loss orders give you a false sense of security, these stocks can make huge downward gaps.

It’s not all doom and gloom. There are plenty of opportunities for disciplined traders who are willing to do some research but, please, be careful.

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Chris Dios is an American writer and entrepreneur based in the Greater NYC area.

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