Penny Stocks: How to Invest In Them

Investing in low-cost stocks may seem wise if you’re trying to grow your wealth. After all, you aren’t spending several hundred or even a thousand dollars per share. But while it’s true that you can invest in a broader range of companies by purchasing penny stocks, are those companies worth investing in?

In many cases, the answer is no. Buying shares of penny stocks—stocks that generally trade for below $5 a share, down to a cent or less—is very risky, and you could lose your investment.

Here’s what to know about these low-cost stocks, how they work, where to trade them, and more.

Understanding penny stocks

The exact definition of penny stocks varies. While the U.S. Securities and Exchange Commission previously defined a penny stock as a small company stock valued at less than $5, others deem it small company shares valued at less than $1. Penny stocks may also be referred to as microcap or small company stocks.

How do penny stocks work?

Penny stocks may trade on large public exchanges such as the New York Stock Exchange, but they often trade over-the-counter (OTC). OTC trading is done via a decentralized network where two individuals make trades directly with the help of a broker. Because they often trade via an OTC network rather than a centralized exchange, these stocks may be relatively illiquid due to a lack of buyers, which means you may be stuck with them for a while after investing.

Price fluctuations of penny stocks

Since penny stocks are generally shares of smaller companies with fewer resources, they tend to be a volatile investment. Even small price swings could result in the loss of your entire investment—even more if you bought on margin.

For this reason, it’s important to consider your overall risk tolerance before buying a penny stock. While these stocks may be suitable for an experienced investor comfortable with buying high-risk assets for potentially higher gains, they’re likely not a good choice if you’re a beginner or risk-averse.

Penny stocks: Pros and cons

Advantages

Low-cost investment

One of the primary advantages of penny stocks is that they’re a low-cost investment. This means the barrier to entry is low, and you can invest with a small sum.

Could result in big gains

You could see some big gains because they carry such a low price tag. Shares of household names like Ford Motor and Amazon began trading as penny stocks.

Could help small companies grow

Another perk of investing in penny stocks is that your investment can help smaller companies grow, allowing them to further advance their products and services and onboard new employees.

Disadvantages

High-risk investment

While penny stocks have a high potential upside, they’re often volatile and you can lose your investment. Those who buy them on margin could lose even more than that. Besides the risk of loss, it can be difficult to tell if a penny stock is fraudulent because there may not be much information available about the company you’re investing in.

Often illiquid

Securities on a centralized exchange like the New York Stock Exchange (NYSE) often have a relatively large trading volume, but this isn’t the case with OTC stocks. Trading volume is often very low, so you won’t necessarily be able to sell your penny stocks whenever you want.

Limited company information available

The small companies that trade OTC aren’t required to file paperwork with the SEC or other financial regulators, and they may be newer companies trying to raise capital. For these reasons, you may find limited information about their history or financials. Investing in companies without understanding this information could leave you vulnerable to risk.

Tips for investing in penny stocks

Understand your risks

Before investing in penny stocks, it’s important to understand all of the risks involved, as well as your own risk tolerance. This type of investment is often illiquid and highly volatile, and there’s also an increased potential for fraud with penny stocks due to fewer regulations.

Find a reputable broker

As mentioned, some penny stocks trade on major exchanges you can access with a typical online brokerage account. Trading microcap or small company stocks through a reputable broker like Fidelity or another large investment firm could help shield you from some risks. If you’d like to invest via the OTC market, consider a platform like OTC Link, which is regulated by the U.S. Financial Industry Regulatory Authority (FINRA).

Research potential investments

There may be limited information about companies trading on the OTC market, but it’s still essential to do your due diligence before investing. Research company history and available financial information, and contact your state’s securities administrator to determine if the company is legally allowed to sell its shares in your area.

Where to trade penny stocks

How to make money with penny stocks

There’s no surefire way to make money with penny stocks. If you decide to invest in these low-cost securities, do your research to ensure you’re investing in a reputable company. The timing of your investment, company performance, and the market will all play a role in whether your investment increases or decreases in value. 

Example of a penny stock

Residential real estate company Compass, which trades on the NYSE, could be considered a penny stock under the SEC definition. As of May 22, 2024, this company’s shares are trading at around $4.20. 

Past penny stocks include major companies like Amazon, Ford Motor, and Monster Beverage Corporation. Amazon currently trades at around $183 per share, Ford is around $12.03 per share, and Monster Beverages trades at $53.09 per share, as of May 22, 2024. 

TIME Stamp: Penny stocks are too risky for the average investor

Penny stocks are a cheap but risky investment

While the upside potential of penny stocks is significant due to their low cost, there’s also a good chance the company you’re investing in declines in value. Penny stocks investing is best for experienced investors with a high-risk tolerance. If you are a new investor without a large sum to invest, consider purchasing fractional shares of a blue-chip company or low-risk fund instead. Contact an investment professional for further guidance. 

Frequently asked questions (FAQs)

Where do you buy penny stocks?

You can buy certain penny stocks on major stock exchanges or decentralized OTC exchanges like OTC Link. Remember that some OTC exchanges have no minimum requirements for companies, such as a set amount of assets or shareholders. 

Are penny stocks a good buy?

Certain penny stocks may be a good buy, but it’s essential to read up on company history and financials before making an investment. Investing in penny stocks comes with significant risks. 

What are the top five penny stocks to buy?

The top five stocks will forever shift because the market for penny stocks is so volatile. Check with reliable investment sources, such as Morningstar, to find the well-rated stocks when you want to buy. Research carefully before you buy. Set a goal for growth and, if you hit it, consider selling and taking your profits.