Maybe you’ve heard about some lucky investor who made 100x returns on their investments, or watched The Wolf of Wall Street, in which the film’s protagonist gets rich very quickly by selling penny stocks.
Either way, these low-priced shares seem to be attracting new traders... but for the wrong reasons.
What are penny stocks?
According to the Securities Exchange Commission (SEC) – an independent federal government agency responsible for protecting investors – a penny stock is an asset that trades under $5.00 per share.
Penny stocks can be listed on classic stock markets like the NYSE or NASDAQ, or on over-the-counter markets (OTC).
Why would anyone buy penny stocks?
You may be wondering what’s all the hype about penny stocks anyway. Well, the truth is that investors who choose to go down the penny stock route may enjoy some benefits.
- Penny stocks are cheap, so investors can buy a greater amount of shares than they would normally do with traditional stocks.
- Their low price also makes them attractive because investors don’t need a huge amount of capital to start investing.
- They increase quickly, so you can make big money in a short period of time. For example, if you buy 100,000 shares at .0001 ($10,000) and the stock shoots up to .0010, you’ll make $100,000 in profits in a matter of minutes or a few days – just as long as you are able to sell your shares.
- Since investments are not huge, the chances of incurring heavy losses is less, even if your penny stock nosedives.
Are penny stocks a bad choice?
Penny stock investing doesn’t sound too bad so far, does it? Well, there are some risks, which you should definitely know about before investing in these low-priced financial assets.
First of all, companies selling penny stocks are not regulated by independent federal government agencies, so they don’t have to follow any financial reporting guidelines or norms.
This means that you’ll be the only one responsible for your investments. If the company you invested in files bankruptcy, you run the risk of losing your funds.
Penny stocks are unpredictable, making them a high-risk investment option. Their price can swing 10%, 20%, 50%, or even 100% in one single day.
Although this is part of their attraction, since there’s a chance of earning big money in minutes, you should always consider volatility and systematic risk.
Yes, the price of penny stocks may go up very quickly, but it may fall at the same pace. So always be sure to keep in mind that high volatility means high risk for your investment.
Penny stocks are illiquid, which means it’s hard to sell or exchange them for cash without a substantial loss in value. For instance, let’s say you invest $10,000 in shares priced at $0.25, and then the price jumps to $1.50. You’ve just earned $60,000 almost instantly! Awesome, right?
Unfortunately, this is just an illusion. Since these companies are highly illiquid, you might be waiting around for buyers for days, leaving you unable to sell your shares at that price.
So even if their stock price fluctuates wildly in very short periods of time, it might be difficult to sell a penny stock when the time’s right.
Should you trust a company that is not regulated? Should you invest in a company that doesn’t meet the standards of a major market exchange? The obvious answer is no.
We can see why buying stocks for low prices to make large profits after you sell them in a matter of days might be appealing. But there's no guarantee that you will be able to make a return, and the risks are simply too great to offset any possible and realistic benefits.
Instead, it is recommend investing in quality stocks and indexes that you understand, as well as companies that you know and love.
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