Breaking Down Penny Stocks: Are They Worth the Investment?

You may be somewhat familiar with penny stocks, whether from an article, a tv show segment, or the popular 2013 movie, “Wolf of Wall Street.”

With a name like “penny stocks”, you can guess their worth and why so many on Wall Street don’t bother to analyze them.

Typically, penny stocks are those of early-stage, growing companies, which means they’re smaller. Although the actual definition of penny stocks has changed over the years, the way they’re used has remained the same.

People will buy penny stocks because they feel there is less downside associated, and potentially greater upside. Others may feel better knowing they’re investing small amounts, so even a loss wouldn’t hurt them too much.

But what is the truth to penny stocks? Keep reading to find out.

What are Penny Stocks?

In years past, penny stocks were considered to be any stock that traded for less than one dollar per share. Today, a typical penny stock is considered a stock of a small company that trades for less than $5 per share.

Penny stocks are considered to be highly speculative, meaning they carry a significant risk. While you can make money on penny stocks, you can also lose your entire investment.

The reason penny stocks are so risky is due to the size of the company associated with the stock. Smaller companies have a higher chance of going under than larger, more established companies.

With that being said, smaller companies also have a greater chance of doubling their size. So the volatility of penny stocks can swing both ways.

Small companies that trade infrequently are usually associated with penny stocks as well. This means that the company lacks liquidity or doesn’t have buyers available in the market.

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How Much Does It Cost to Trade Penny Stocks?

Knowing that penny stocks typically trade for $5 or less, how much does it actually cost to trade them? Well, that depends on the brokerage service you choose to use.

Some online brokers will offer you flat-fees for trading penny stocks. An example of this would be a broker attaching a $5.00 flat-fee when you buy or trade.

Other brokers might charge you per-share rates for trading penny stocks. An example of this would be a broker charging you $.0040 per share with a max cost of 0.5% of the trade value.

Let’s say you buy 10,000 shares of a particular penny stock at a price of $.13 per share ($1,300). The 10,000 shares multiplied by the $.0040 per share is $40, while $1,300 x .5% is $6.50. Thus, your cost to buy the shares is $6.50 (0.5% of trade value).

It can be inexpensive to trade penny stocks if you use the right broker. A flat fee will help you keep your costs down, but a per-share fee could make things a bit more expensive.

It’s a good idea to avoid monthly charges for using the brokerage’s platform or data fees. These add up quickly and can make penny stocks unworthy of investment.

Where Can You Find Penny Stocks?

Ready to buy penny stocks? First, you’ll need to know where to buy penny stocks. While you can find some penny stocks in the New York Stock Exchange, NYSE, and similar large exchanges, most of them are traded through over-the-counter transactions, or OTC.

OTC trading can be done through the electronic OTC Bulletin Board, OTCBB, or the privately-owned OTC Markets Group. Unlike the NYSE, there is no trading floor for OTC transactions; everything is done electronically.

If you want to trade penny stocks in the major markets, the penny stock must satisfy multiple requirements. For example, the NASDAQ Rule 5550 (a) states that equities must maintain a minimum bid price of $1 per share.

You can also find penny stocks on pink sheet listings. A pink sheet listing is specifically for stocks that do not meet major stock exchange requirements, such as penny stocks.

Because pink sheets deal with such low-value stocks, they are also considered high risk. You may not put much into these stocks, but you can just as easily lose your entire investment if you do not invest wisely.

Difference Between Small-Cap Stocks and Penny Stocks

Now that you have a better understanding of what penny stocks are, you might be wondering how they are different from small-cap stocks.

While it’s true that they both represent shares of companies with a low market capitalization, there are distinct differences.

For one, penny stocks are often traded over OTCs instead of stock exchanges. Penny stocks also usually trade at low prices and low market capitalization.

On the other hand, small-cap stocks are typically traded over stock exchanges. Small-cap stocks are based solely on a company’s market capitalization, not its stock price or where it’s being listed.

You’ll also find small-cap stocks in small-cap indices, such as the Russell 2000 Index, where you wouldn’t find penny stocks.

Whether you are investing in penny stocks or small-cap stocks, you’re taking on a risk. Since they both represent shares of companies with low market capitalization, they carry more risk than mid- or large-cap companies, which have outgrown the more vulnerable early stages of growth and are considered less likely to fail.

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