Are Penny Stocks High Risk?

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Are Penny Stocks High Risk?

 Are Penny Stocks High Risk?
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Summary

  • Penny stocks are companies that are small, young, or in trouble.
  • Stocks often trade “over the counter market groups”, or OTC Bulletin Board (OTCBB).
  • Penny stocks are of low cost and easier to invest, but they can be risky or rewarding.

 

Shares priced less than US$5 are considered penny stocks. They are typically sold over the counter. Stocks are attractively priced, but they may come with risks like volatility and scams. Buying penny stocks through established dealers is considered safe.

Penny stocks have become popular over the years because of their low cost. In addition, modern technologies that offer the ease of trading from home have contributed to their growth.

What are penny stocks?

The US Securities and Exchange Commission (SEC) defines penny stocks as shares of smaller companies that cost less than US$5. The SEC is a federal government agency that works to protect the interest of investors. Earlier, all stocks priced less than US$1 were deemed penny stocks. But recently, the SEC has changed the definition.

Penny stocks are often called micro-caps, nano-caps, or small-caps.

Also read: 7 Hot Penny Stocks To Watch In June 2021

Penny stocks are mostly traded via Over the Counter (OTC) transactions at privately owned OTC Market Groups, called Pink Sheets or electronic OTC Bulletin Board (OTCBB). However, some penny stocks are traded at bigger stock exchanges like NYSE.

Companies traded through Pink Sheets or OTC Market Groups do not require to file trade details with SEC. Hence, a thorough knowledge of the companies is needed before investing in them. Also, details about such companies are seldom available on the internet. As a result, investors sometimes struggle to buy penny stocks due to a lack of information about the companies. Besides, nobody knows whether such a company will grow or perish.

Young or less known companies generally sell their stocks for less than US$5. But sometimes, well-known or old companies also sell their stocks at less than US$5 if they are facing losses or legal issues.

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How are penny stocks created?

Generally, small companies or start-ups want to grow their business and need capital. So, to raise money, companies register for initial public offering (IPO) with the SEC. Once the SEC approves their plan, the companies list their shares at OTCBB or OTC Market Groups.

Who invests in penny stocks?

Generally, inexperienced or new investors are more likely to invest in penny stocks, lured by the prospect of higher returns from less investment. Also, they get influenced by stories of people claiming to receive 200% or more returns on penny stocks. So, the idea of investing US0.10 per stock of a start-up and receiving US$1 or more is fascinating for many. Also, experienced traders who know about the company or have faith in its growth will invest in such stocks.

Also read: Three US Penny Stocks Whose Price May Skyrocket in 2021


What are the risks involved in penny stocks?

These companies are generally young or untried or in troubles. Amazon had begun its journey as a penny stock company. But not all companies can become like this tech giant. Micro-cap companies may or may not perform well.

Fluctuations in stock prices can swing in both ways - massive gains or terrible losses for investors. And price volatility might not always take an upward trajectory. In fact, SEC has warned investors that they should be ready to lose their investment in penny stocks.

Penny stocks are not considered cash as they are not easy to sell. Not many people trade in penny stocks; hence, investors may face difficulty in selling them.

Also read: Is It Good To Invest In US Stocks?

Companies selling penny stocks are not required to file their financial reports with SEC. Thus, no information about their balance sheet is available in public. And it is difficult for investors to know the financial health of the company. It can cause lots of frauds or scams. For example, fraudsters buy thousands of penny stocks and tell others to buy them. Many times, these are shell companies without having an asset or any business.

 

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What precautions should be taken before investing in penny stocks?

SEC or local government authorities may be useful in obtaining credible financial information about these companies before deciding whether to buy such stocks. Besides, companies often promote newsletter with financial details that look credible.

But information from credible sources needs to be trusted. Diversifying the stock portfolio is another way of minimizing risks. Risks are higher when the entire sum is spent on one stock. Dealers who are known for credibility can be helpful in securing details about the penny stocks.

Also Read: Three small-cap stocks that can make a giant leap in 2021

Penny stocks are not considered long-term hold stocks. Investors should know when to sell them, which is when the stock price goes up. Companies run by experienced managers or those backed by unique skill sets, like biotechnology companies, are preferred by professional traders or companies with solid fundamentals but are currently running into troubles due to external reasons. 

Stocks listed at OTC-QX, OTC-QB, and the pink OTC market don’t have to file their balance sheets. And hence, they are not necessarily trustable. In contrast, stocks listed at NYSE or NASDAQ have to file periodic financial statements for their investors.

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