What Are the Risks of Trading Penny Stocks?
Penny stocks are stocks with a share price under a dollar. However, some brokers put stocks trading below $5 a share in the penny stock category. This category of stocks has traditionally attracted a great deal of investor speculation due to the fact that small moves of just a few cents represent large percentage gains. For instance, if a stock trading at $0.05 a share moves up a penny, investors earn almost 25 percent. Penny stock risk, however, can be extraordinary.
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Pump and Dump
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Fraud has historically been rampant in the penny stock markets. The "pump and dump" scam is one of the primary methods used to defraud investors. Many penny stocks have lower than average trading volume, so it doesn't take a lot of buyers to move the price significantly higher. The method is quietly buy a large number of shares and then hype the prospects of a company to investors -- this is often done by telemarketers. Once the price is sufficiently high, the con artist sells his shares, leaving new investors with a big loss. Pump and dump is illegal, but it still happens.
Illiquidity
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Stock liquidity is important for investors and traders as it lets them enter and leave a position quickly without causing a large price move. Penny stocks that trade only a few thousand shares a day can be notoriously difficult to buy and sell. The spread between the bid price and asking price can be wide. In addition, if the need arises to sell quickly due to falling share prices, investors oftentimes find they are forced to sell at much lower prices than they would like in order to find willing buyers.
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Bankruptcy
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Penny stocks are worth pennies for a reason. Many investors are under the misconception that stocks like Microsoft and Google once traded for pennies a share and they search through penny companies looking for the next big winner. Microsoft started above $25 a share and Google started at $85. Stocks trading below a dollar are typically companies undergoing bankruptcy proceedings or they are small, underfunded companies with little or no earnings potential.
Lack of Regulation
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Once a stock trades below a dollar, it becomes ineligible to trade on any major stock exchange. This category of stock is traded in the over the counter market, or OTC. The OTC market is largely unregulated. Exchanges have rules that outline trading practices and company reporting. Stocks on the OTC market are more prone to manipulative trading tactics, and investors oftentimes find it difficult to find accurate company earnings reports and other important financial information. This means that penny stock investors are often in the dark about the potential of the companies they buy shares in.
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References
- Photo Credit penny fingers image by Sean Arenas from Fotolia.com
