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What Are Penny Stocks and Should You Buy Them?

Chris Dios - October 04, 2019

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If you’re just getting into trading, you’ve probably heard a lot of talk about penny stocks. However, the name is a bit of a misnomer. Penny stocks don’t cost a penny – not all of them, at least – but they are very cheap compared to the rest of the market. So, what are penny stocks anyway?

If you’re looking for this month’s best penny stocks, you’re in the wrong place. You can find this month’s top penny stock picks here.

Definition of Penny Stocks

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Penny Stocks are Stocks That Currently Trade for Less Than $5 Per Share

You might be asking, “what are penny stocks?”. The answer isn’t as complicated as you may think and it actually doesn’t have anything to do with pennies.

Penny Stocks (n): A stock or security that is currently trading for less than $5.

That’s it. If a stock costs less than 5 dollars to buy, it’s considered a penny stock. Some very cheap options actually cost a penny, or even less, but these tend to be very risky stocks from small companies.

If you have a bigger budget for buying stocks, check out the Dork’s best stocks under 10 dollars.

Characteristics of Penny Stocks

Penny stocks are high-risk, high-reward assets that can make or break your portfolio. Despite the risks, these types of investments are extremely popular because of the incredible potential profit they can offer the average, low-budget trader. Buying a round lot of penny stocks costs a lot less than buying a round lot of more expensive stocks, so just about anyone with a brokerage account can afford to make moves.

However, none of these traits are universal. The only truly common characteristic shared by all penny stocks is a cost of less than $5 per share, but even that can change. Stocks oftentimes go up in price, and when a stock’s share price goes above $5 it loses its penny-stock status.

What Are Penny Stocks: Investment Risks

Now that “what are penny stocks” has been answered, let’s talk about risks.

All stocks carry risk. Some of those risks are foreseeable, but many are not. Every company has its ups and downs, but smaller companies don’t have the firepower to cope with adversity like larger blue-chip firms. If a small company hits a few bad quarters in a row, they might go out of business. Conversely, big firms often have enough cash to stay afloat, even if there is a prolonged crisis.

Lower Risk Options

While all penny stocks present significant risks, some are more stable than others. If you want to look for options with the least inherent risks, screen for penny stocks that are listed on major exchanges.

Companies that want to list on the Nasdaq and NYSE have to meet strict regulatory requirements before they can get there. Once they’re on the exchange, they still need to comply with the listing standards. The regulatory hurdles help to keep out the riff-raff and ensure that every exchange-listed company is at least somewhat reputable.

More Risks, More Rewards

If you’re willing to take a little more risk for the chance at much higher rewards, you may want to expand your search to include the OTC markets. OTC stocks comprise the vast majority of the penny stock universe so you will have to consider them if you want to really get into the game. Out of all of the OTC market, OTCQX has the highest listing standards so it’s a good place to start for beginners. Its standards are lower than Nasdaq or NYSE, but its better than nothing.

You need to do your homework if you want to trade OTC stocks. The listing requirements are pretty low, so the market is a breeding ground for ‘pump and dump’ scams. Make sure the company you’re trading is a real company, with real earnings, before you buy. If you get caught on the wrong end of a pump-and-dump scam, you can easily lose your entire principal investment.

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Trading Penny Stocks Can Be a Risky Endeavor. Be Sure to Do Your Due Diligence.

Safer Alternatives

If talking about all of these risks are starting to make your stomach turn, stocks might not be your best option. If you’re looking for safer investments, check out our post on top gold stocks. Gold is considered to be a ‘safe harbor’ asset because it tends to perform well in times of economic uncertainty.

Where to Trade Penny Stocks

Buying penny stocks is as easy as buying any other stock. If you’re using a discount mobile broker, like Robinhood or WeBull, you’ll only be able to access exchange-listed stocks. Learn more about WeBull on our WeBull review page. As of now, neither of these brokers offer access to OTC markets. However, you can still access all of the major exchange-listed stocks, including those trading for less than five bucks. There’s nothing wrong with sticking to exchange-listed stocks, but you’ll have to find an OTC markets broker if you want access to the full market.

To trade OTC markets, shop larger brokers like TD-Ameritrade and Schwab. These full-service brokers provide traders with access to a diverse selection of investments, including OTC stocks. Best of all, many of the big-budget, old-school brokers are dropping their trading commissions to zero. That means you can trade OTC stocks – or any of your favorite stocks – for free. Best of all, most of these brokers provide free access to expert research and analysis tools. However, most analysts don’t bother to cover penny stocks so there’s no guarantee that you will be able to find professional research reports for the stocks you’re shopping.

Should I Start Trading Penny Stocks?

That depends. Ask yourself what your tolerance for risk is before you make any decisions. Expert traders consider penny stocks to be speculative investments. That puts them in the same class with bitcoin, derivatives, and other whacky financial instruments. Don’t invest any money in these assets that you can’t afford to lose.

If you’re a long-term investor who buys stocks and holds them for years, you might want to look elsewhere for trades. Many smaller businesses to survive into maturity so a lot of the stocks trading today won’t exist 10 years from now. Cheap stocks are especially risky because their respective companies are less equipped to combat unpredictable events. If you’re shopping for your IRA or 401(k), penny stocks probably aren’t the best fit. Do you think you’ve got a real-deal, long-term winner on your hands? Then pull the trigger. Just be conservative and don’t invest any money that you aren’t willing to lose.

Day traders and swing traders like trading these types of stocks because they’re often very volatile assets. Short-term traders love volatility because it gives them plenty of opportunities to turn profits. If you’re more interested in stick-and-move trading, then penny stocks are definitely worth a look.

Should you start trading penny stocks? The answer is, maybe. It all depends on your financial situation and your trading styles. As always, be sure to do your own due diligence. You may even want to consult with a financial advisor before you get started. If you’re retired or getting close to the finish line, don’t take any chances. You don’t have as much time to make back your losses as younger investors.

It Will Cost You More Than This to Invest In Most Penny Stocks, but The Rewards Can Be Huge If You Can Pick Winners.

What Are Penny Stocks: Final Thoughts

You asked ‘what are penny stocks,’ and now you have your answer. Now that you know what they are, what’s next? A good place to start is our best stocks under 5 dollar rankings. It has the latest top stocks and it’s updated monthly. Check out the rankings now.

Stay up on the hottest stocks by signing up for FREE Stock Dork Alerts, and don’t forget to follow us on Facebook, Twitter, and Google News for the latest stock market news.

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

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