Penny stocks are incredibly inexpensive and have the potential for above-average returns. There’s serious appeal there for new investors, but learning how to buy penny stocks means understanding all of the risks associated with them.
If you’re interested in buying penny stocks, this guide will explain what they are, how to buy them, the best brokerages for penny stocks, and the risk associated with buying them.
What is a penny stock?
Penny stocks typically refer to stocks that trade for less than $5 per share. While most traders buy penny stocks via over-the-counter (OTC) transactions through the privately owned OTC Markets Group or through the electronic OTC Bulletin Board (OTCBB), still some penny stocks are traded on large exchanges like the New York Stock Exchange.
In the past, any stocks under $1 were considered penny stocks, but the U.S. Securities and Exchange Commission (SEC) modified the definition to include all shares trading under $5.
Even though $5 or less seems like a small and feasible investment, penny stocks are riskier than regular stocks.
What makes penny stocks riskier?
The biggest reason penny stocks carry more risk is because they lack liquidity. Because they are usually associated with smaller companies and trade infrequently, meaning they have fewer buyers in the marketplace. A lack of liquidity means it may be difficult to sell your share or even find a price that accurately reflects the market.
Small companies may use penny stocks as a way to access funding from the public like a starting block before they move to a larger marketplace.
Because of the types of companies using penny stocks and the lack of liquidity, there’s more volatility with penny stocks, which results in wide bid-ask spreads or price quotes. Buying penny stocks is highly speculative for that reason, and investors can lose a decent amount of money if they’re not careful.
Here’s an example: Let’s say you buy penny stocks at $0.50 a share. If they go down $0.25 a share, you’ve lost half of your investment. Imagine investing $1,000 in those $0.50 shares — you’d lose $500 in that scenario.
Some investors see the volatility associated with penny stocks as a higher potential for reward, which is true. The possibility of explosive gains is incredibly attractive.
However, the inherent risk of buying penny stocks should be considered before investing. It’s important to have realistic expectations before you get started.
How to buy penny stocks
Now that you understand the risks associated with buying penny stocks, here are the steps educated investors take to buying them:
Step 1: Do your research
Research is key for any good investment — you need to know that you’re making an investment in a legitimate company.
You can start by going to the Securities and Exchange Commission’s website to get the company’s most recent filings, which give you information about the company’s overall financial health. The SEC website will also tell you if the company has recently been delisted from a major exchange.
Many investors focus on penny stocks that carry the “OB” suffix to their symbol because these ones are required to file financial statements with the SEC. Penny stocks that lack the “OB” suffix don’t receive the same public scrutiny or regulation.
This step takes time, but considering the risk associated with buying penny stocks, your time is a solid investment.
Step 2: Where to buy penny stocks
There are a number of brokers out there that trade penny stocks. Even though not all of them trade on a major exchange like the NYSE, they can be bought through a brokerage that specializes in OTC (over-the-counter) trading.
Below are some of the best brokers for penny stocks:
$0 per trade
$0 per trade
$0.005 per share, as low as $0.0005 with volume discounts
When choosing the best broker for penny stocks, you really want to pay attention to surcharges. Many brokerages charge $5 or more per penny stock transaction, which can make these trades expensive. Fortunately, all of the brokerages above charge $0 to minimal fees to trade penny stocks.
Here are some other things to consider when deciding on a broker to buy penny stocks:
- What kind of built-in tools does the brokerage’s platform offer? Having access to research tools, streaming feeds, and other technical indicators may be important to you.
- What is the brokerage’s history like? During the great GameStop short squeeze of ‘21, some brokerages shut down trading, which really aggravated investors. Paying attention to things like that, plus customer service may push you towards one brokerage over another.
- What other securities do they offer? Does the brokerage also offer options or crypto? Are there any other securities you’d like to trade?
- What about short selling or trading on margin? These are risky investment strategies, but if they’re important to you, make sure the brokerage allows them.
Step 3: Decide which stock to trade
The OTC Markets website is a good starting point. It gives you a list of currently advancing and declining stocks plus historic charting data. This site also lets you access SEC filings and disclosures, news about the company, and more.
Step 4: Start trading
After you have a brokerage and know which penny stocks you want to trade, now it’s time to start investing. You’ll have to be comfortable losing some of your investment (or all of it!).
It’s a good idea to set an investment budget, and reputable advisors would recommend maxing out your retirement investments first before putting too much of your budget towards penny stocks.
Risks of trading penny stocks
We’re already talked about some of the risks associated with learning how to buy penny stocks, but those aren’t the only risks. Below are the reasons penny stocks fail and why they’re risky:
Lack of liquidity
Penny stocks aren’t traded as frequently as blue-chip stocks and others that trade on major markets like the NYSE. This infrequent trading means penny stocks are less liquid. For investors, that illiquidity means it may be difficult to sell your penny stocks once you’ve acquired them.
To offload them, you may have to lower the price you’re willing to sell at. Overall, the lack of liquidity is a serious pitfall because it leads to losing money and is why many penny stocks fail.
Another danger of low liquid levels is that it creates an opportunity for traders to manipulate stock prices. Pump and dump schemes are popular trading scams that lure investors into buying penny stocks. Once large amounts of stocks are purchased, there’s a period when the stock is pumped up. More investors buy, then scammers sell their shares.
It takes a minute for the market to realize there was no fundamental reason for the price increase, leading average investors to rush sales and take heavy losses.
Lack of information
Research is an incredibly important aspect of investing, but there’s a lack of information for some penny stocks. For example, penny stocks that don’t carry the “OB” suffix on their stock symbol aren’t required to file with the SEC and lack regulation and public scrutiny.
Avoiding those stocks and sticking to credible sources will help you get the most accurate information possible.
Lack of history
Another thing penny stocks lack is history. Generally, companies considered penny stocks could be newly formed. New companies just don’t have the same track record as an established stock.
It’s also worth mentioning that many new companies fail, and it’s difficult to see what’s happening when there’s a lack of historic information.
No minimum standards
OTCBB stocks and stocks sold on pink sheets aren’t required to fill the same minimum standard requirements needed to remain available on OTC exchanges. Minimum standards are important to some investors because they act as a safety net. Fewer standards equal more risks, it’s just that simple.
Pros and cons of buying penny stocks
How to buy penny stocks – is it worth the risk?
Buying penny stocks is risky and not for everyone. If you fully understand the risks and still want to proceed, do so with caution and as much knowledge as possible.
You’ll want to start by finding a brokerage that sells penny stocks — Firstrade has $0 commissions on penny stocks and no account minimums. Then, fund your account and decide which penny stocks to buy.
Penny stocks are more risky than regular stocks, but there’s the potential for higher-than-average returns. You’ll need to weigh up the pros and cons before deciding to buy penny stocks.
Yes, it is possible to make money with penny stocks. Technically, it’s possible to make money on any kind of stock. But you should be aware of the risks before investing, and penny stocks have a much higher risk because they’re highly illiquid.
It’s thought you can get rich off penny stocks because there’s the potential for higher than average returns. They can turn a very small investment into a large chunk of money. However, penny stocks are more volatile and less liquid than regular stocks, so there’s a considerable risk of losing money instead of getting rich.
The only penny stocks Robinhood has are ones that trade on either the NASDAQ or NYSE, and they do not support trading OTC stocks.
Savvy investors suggest having at least $5,000 ready to start buying penny stocks. Ultimately, penny stocks are subject to the same trading rules as regular stocks. So if you want to day trade, you’ll need a minimum balance of $25,000 in your account. If you don’t plan on day trading, you’re limited to 3 trades a day and only need enough to buy the stock.