As the saying goes, a penny saved is a penny earned. But when it comes to the high-risk world of penny stocks, a penny invested can result in a penny easily lost. If you don't have a lot of money to invest, the low cost of penny stocks may tempt you to buy them. However, you should do so with extreme caution.
In general, a penny stock is a stock with a vale of $5.00 or less per share. They are not traded on the regular stock exchanges like the New York Stock Exchange. Instead, penny stocks are traded on over-the-counter markets through the use of electronic quotation systems called "pink sheets." Smaller start-up companies with less than $4 million is assets or that do not own tangible assets like buildings and equipment are more likely to issue penny stocks than larger corporations.
Unlike regular stocks where share prices are easily found in a newspaper or online, determining the buying or selling price of a penny stock is a bit more complicated. In a typical transaction, your broker-dealer, also known as an agent, arranges a trade for you based on the bid price, which is the amount someone is willing to pay for a stock, and the ask price, which is the amount for which someone is willing to sell a stock. The difference between the two is known as the spread, which will determine how much profit a broker-dealer can make on a trade.
Profitability and Risk
Factors like the complexity of transactions, the fact that penny stocks are often issued by start-up companies with little track record and that broker-dealer commissions are based on the size of the spread can make it difficult to make money trading in penny stocks. There's also a very good chance that you will lose money. The gambling nature of penny stocks attracts investors who want to get in and out of the market quickly, with the hope of making a fast buck.
A danger of investing in penny stocks is that the market is subject to a high level of price manipulation by broker-dealers. In some cases, their actions can even force companies to go out of business. Unlike typical stock transactions where your broker-dealer makes trades on your behalf, a penny stock broker-dealer can also make trades to benefit himself, meaning he may not necessarily be looking out for your best interests.
Chris Joseph writes for websites and online publications, covering business and technology. He holds a Bachelor of Science in marketing from York College of Pennsylvania.