Before you start to trade or invest in stocks, you’re likely going to look at the price of the stock. What if you could purchase stocks for $1 per share, watch them balloon by 100%, and turn into $100 within a couple of weeks?
Sometimes, traders think they can make more money from low-dollar stocks despite the fact that it sounds too good to be true. However, if you do have the potential for higher rewards, you’ll also experience more volatility and a greater risk of loss.
Here is what you need to know about how to invest in penny stocks without getting burned.
What defines a penny stock?
The Securities and Exchange Commission (SEC) defines penny stocks as the stocks of small companies that are traded for less than $5 per share. Some experts adopt an even lower price-per-share threshold of $1. Penny stocks are also known as micro-cap stocks, and they have a market capitalization of less than $300 million.
Rather than being listed on the Stock Exchange, most penny stocks are usually traded over-the-counter (OTC) through electric marketplaces operated by the OTC Markets Group. Penny stocks are often shares of companies that have non-existent or poor financial histories. Sometimes, penny stocks also represent companies that are on the brink of bankruptcy.
How do penny stocks work?
Penny stocks trade like any other stock except they tend to be riskier. Lower trading volumes mean that stocks exchange hands less frequently, which makes them less liquid.
The low liquidity of penny stocks makes it difficult to find a ready buyer, and you may have to sell your penny stocks for undesirably low prices. The value of penny stocks also tends to swing wildly, making them tricky to trade.
Since penny stocks have a lower share price and smaller market capitalization, penny stocks can be inherently risky. Not only that but penny stocks are often associated with non-credible companies.
Information can be scanty or unreliable because the companies are not covered by large institutional analysts. Therefore, they are not obligated to file with the SEC.
This dearth of information makes it tough to arrive at a good trading decision because of the lack of analytics. Unfortunately, penny stocks also tend to attract inexperienced investors who may not know how to analyze penny stocks.
Additionally, penny stocks can be subjected to pump-and-dump schemes. Pump-and-dump refers to an illegal scheme where price manipulators artificially raise the price of a stock based on misleading or exaggerated positive statements.
The fraudsters have already bought a large chunk of the targeted stock, and they plan to sell their stocks once the hype has been created. From there, they boost the share price, sell their shares, and dump the now-worthless shares onto inexperienced investors who don’t know any better.
Advantages of penny stocks
- Low barrier to entry: It’s easy to start investing in penny stocks since they are priced so low. You can start with a small amount of capital. All you need is a computer or smartphone with an internet connection, as well as a brokerage account, and then you are good to go!
- Potential of outsized gains: Penny stocks are priced much lower than most other types of investments, which makes it possible for investors to buy them in larger quantities. Investing in the right penny stock has the potential to rapidly multiply a small investment in a short amount of time.
Disadvantages of penny stocks
- Lower liquidity: You may find it tough to sell your position due to the low liquidity of penny stocks. The lack of available buyers means you may not be able to make a transaction immediately.
- Price manipulation: Penny stocks are prone to price manipulation. You could also lose your capital to pump-and-dump schemes.
- Little information: The lack of company information makes it challenging for investors to decide on a promising stock.
- No dividend: Most penny stock companies do not pay dividends due to their small size or unsteady financial state.
Example of a penny stock
Axsome Therapeutics (NASDAQ: AXSM) is an example of a penny stock that has had a fantastic run. Axsome Therapeutics Inc. is a therapeutics company based in the U.S.
Axsome Therapeutics gained 3,812% from 2019 into 2020. This success was due to the successful trial of a new drug called AXS-05, which was intended to treat major depressive disorders.
AXSM stock started trading around $2 to $3 in late 2018, and by January 2020, it had hit highs of more than $100 per share. The FDA used the new Axsome Therapeutics drug as a form of breakthrough therapy in late 2019.
Penny stock vs regular stock
Penny stocks are shares issued by companies that trade for less than $5, which is very low considering other types of stocks are priced much higher. Aside from the price discrepancies, there are a couple of other fundamental distinctions.
An investor wondering how to invest in penny stocks will find that they are typically not listed on major stock exchanges like the New York Stock Exchange (NYSE) or the Nasdaq Stock Market. Most other types of stocks are listed publicly, but penny stocks can only be found as over-the-counter (OTC) stocks.
Penny stocks are also traded less often than regular stocks, which makes them illiquid. This means buying and selling penny stocks is less efficient due to the wide gaps between the starting costs and the asking prices.
Penny stock vs small-cap stock
Penny stocks and small-cap stocks are often the shares of companies that have relatively small valuations or low market capitalizations. Penny stocks are designated by the per-share price. They are also typically traded on the OTC market, while small-cap stocks trade via public exchanges.
In contrast, a small-cap stock is categorized purely based on its market capitalization rather than its stock price or listing location. A small-cap stock can be a penny stock, but a penny stock cannot typically be a small-cap stock.
Should I invest in penny stocks?
The attraction people have to penny stocks can often be psychological. It might make sense that a $0.50 stock has more of a chance to double than a $1,000 stock.
However, penny stocks are traded at lower rates for a reason, whether it’s poor fundamentals or diminishing prospects. Stocks from small companies can be extremely volatile, often leading to substantial losses.
With so many investment options available, there’s no reason to gamble on high-risk companies that issue penny stocks. A safer long-term investment would be ETFs. While you can find some penny stock ETFs, you’re still taking on the volatility of riskier stocks when you invest in penny stocks.
MoneyLion offers a fully-managed stock and bond ETF portfolio, making it easy to invest because MoneyLion does all the heavy lifting for you. You also get to tailor your portfolio according to your personal preferences, all for a low monthly administrative fee of $1.
A better alternative
Maybe you’ve heard about massive profits a friend made on penny stocks and now you want a piece of the action. While these investments may sound appealing at first, they are not for the faint of heart.
To trade penny stocks, you have to try analyzing the company and its trading patterns, which can be very hard to predict. You’ll find yourself relying on luck.
Even then, the risk of losing your investment is still high. Putting your money in a MoneyLion investment account offers strategic asset allocation that the pros benefit from.
With a fully managed portfolio and an auto-investing feature, a MoneyLion investment account is one of the easiest ways to reach your investing goals without any minimums or asset-based management fees.
And just like with penny stocks, you do not need a lot of cash to get started with a MoneyLion investment account. Even better, MoneyLion portfolios can offer a more diversified risk profile than penny stocks. A diversified portfolio typically comes with lower risk. Download the MoneyLion app to get started right away!