How to Start Investing in Penny Stocks

Penny stocks are a loosely defined category of highly volatile and risky stocks that often trade outside of the major exchanges at a low price and low market capitalization. The term “penny stock” is misleading because — although some trade for just a few cents — penny stocks can trade for as much as five dollars a share.

Penny stocks are highly speculative, illiquid shares in very small companies, and they aren’t bound by the strict filing or regulatory requirements that govern the major exchanges. Penny stocks are attractive to brazen investors because, despite their significant risk, they have the potential to produce massive returns from modest initial investments.

Related: 31 Things to Know About Investing Your Money

Your Guide on How to Invest in Penny Stocks

Penny stocks — also called micro-cap or pink sheet stocks — are not for the faint of heart. Speculative investors flock to them in the hopes of getting in on the ground floor of the next major global corporation for just a few dollars, or even a few cents, per share. It is crucial for investors to understand what they’re getting into and to develop a solid grasp of how to start investing in penny stocks before they buy.

What Is a Penny Stock?

The Securities and Exchange Commission considers any stock of a “very small company” that trades for under $5 a share to be a penny stock. They generally trade “over the counter,” but could also trade on a secondary securities exchange.

But not all investors agree on that definition, in large part because many successful, large, established companies trade for less than $5 a share, and many small, shaky companies trade for $5 a share or more. Generally, any stock that trades on the pink sheets or the over-the-counter bulletin board (OTCBB) are penny stocks.

Read: How to Start Investing With Less Than $500

How to Research Penny Stocks

Because of their loosely regulated reporting requirements, penny stocks are notoriously difficult to accurately research. It is much easier to manipulate the price of a stock if the company’s reporting isn’t clear and thorough regarding whether the business is losing money or making money and why.

Ask your broker or advisor if any pink sheet business you are considering files financial reports with the SEC. If so, ask your broker to get you written information about the company, its management and its finances. Meticulously read the company’s financials and prospectus.

Also, you can contact the company directly and ask if it reports to the SEC. If it does, you can ask the company for its financial reporting. You can also seek this reporting from your state securities regulator or the Secretary of State where the company is located.

Don’t invest until you:

• Find out if the company registers its securities with the SEC or state regulators.
• Get a clear understanding of the business, its industry and what it does.
• Read the company’s most recent reports. If it does not file reports with the SEC, ask your broker for the company’s Rule 15c2-11 file, which contains important financial information.
• Cross-reference the company’s management against records from your state’s securities officials regarding the people running the business and any past run-ins they might have had with regulators.

How to Find a Penny Stock Broker

“The Wolf of Wall Street” was based on a broker who made millions of dollars by pushing shady penny stocks. A recent New York Times article reported on a litany of brokers who federal investigators charged after breaking up sketchy penny stock manipulation schemes. Sometimes, the broker — who is supposed to look out for the interest of the investor — is the one the buyer should be most skeptical of.

It is an absolute necessity to find a good broker to guide you through the murky financial reporting associated with penny stocks. Look for a broker who trades online — almost all do now. Trading something as volatile as penny stocks over the phone can lead to big price swings during the short time between when the trade was ordered and when it was actually placed. A mobile app is also a good sign of a legitimate, established broker.

Also, understand the difference between your depository, or dematerialized account (demat), and your nostro. Your demat is where you keep your shares. Your nostro is where you keep your trading funds.

Every penny stock broker offers a demat, but very few offer a nostro. Make sure to choose a broker who offers both. Penny stocks are about timing, and if your money isn’t fluid and gets tied up during transactions because you don’t have a nostro account, you can miss crucial windows of trading time that lead to price fluctuations.

Stock Broker Fees to Avoid

Finally, watch out for charges. It is always important to get a clear representation of broker commissions and fees, but never more so than with volatile investments like penny stocks. Because penny stocks are generally traded in very high volumes, look for brokers who charge a flat rate instead of a per-share fee structure.

Watch out for transaction charges, minimum per-share charges, minimum per-order charges, large order charges, frequent trading charges, charges for maintaining an account, inactivity fees, minimum deposit charges and withdrawal fees.

“Commissions are as high as 50 percent for the broker selling penny stocks,” said Jeffrey A. Bogart, registered investment advisor with Sila Wealth Advisory.

Here are some reputable brokerage firms that deal in penny stocks:

• E-Trade
• TD Ameritrade
• ChoiceTrade
• TradeKing
• SureTrader
• Scottrade

How to Pick Penny Stocks

According to Money Morning, Monster Beverage (MNST) was a penny stock worth just $1.28 in 2004. By 2006 — just two years later — it had gained 7,800 percent in value after climbing to over $100 a share.

Read: How to Invest in the Share Market

Some penny stocks are fortunes waiting to be made, but they are few and far between, and the pink sheets are littered with financial landmines. Stick to stocks that trade on major indexes like the New York Stock Exchange. Because of its loose reporting standards, the OTCBB is a natural haven for scammers.

Also, pink sheet stocks are classified as either “PrimeOX” or “PremierOX.” Deal only in Premier OX stocks, which sell for at least $1 a share and have at least 100 shareholders who own at least 100 shares each. PrimeOX stocks have no minimum.

Choose “ready for market” stocks or “buyout candidates.” Ready-for-market stocks represent companies, like tiny biotech firms, that have spent years researching and developing a product or service that is ready to be brought to market, according to Money Market. If the product succeeds, it could launch the company into the mainstream. Buyout candidates are companies with solid financials in niche markets that larger companies might be poised to purchase.

Penny Stock Risks and Rewards

Penny stocks involve four main risks, according to Nasdaq. First, there is a shortage of tangible information associated with penny stocks, which makes it hard for investors to make fully informed decisions. Pink sheet stocks aren’t required to file with the SEC, and therefore, reporting information is often spotty or derived from sources that aren’t credible.

Second, OTCBB stocks don’t have to meet minimum standards to stay listed. Companies listed on the NYSE or Nasdaq, for example, must meet minimum requirements designed to safeguard investors.

Third, penny stocks frequently have short business histories or no business histories at all. They could be newly formed or they could be nearing bankruptcy.

Finally, penny stocks lack liquidity, which means it might be difficult to sell a stock once you buy it. This difficulty could force you to lower the selling price until a buyer finds the price attractive. Low liquidity also gives unscrupulous investors several opportunities to artificially inflate the price of a stock to sell to unsuspecting investors.

Why People Take a Chance on Penny Stocks

People are often attracted to penny stocks because of their low prices, but these stocks can lose a great deal of value with a drop of just a few cents. “Just because its price is 30 cents per share doesn’t mean it can’t go lower or become worthless,” Bogart said.

Even with all this potential danger, penny stocks lure investors — especially new investors — because large quantities of stock can be purchased for a minimal amount of money. If shares of a penny stock achieve even modest gains, the returns could be enormous. For example, if someone buys 5,000 shares of a company for $1 a share, and that stock price rises just 25 cents, the investor earns $1,250.

The Bottom Line

Penny stocks are a risky, murky area of the financial world. They are more of a gamble than an investment. But many investors are drawn to them because of success stories like Monster Beverage, which started out as a penny stock but evolved into a major corporation. Those who purchased large number of shares when they were floating around a dollar reaped huge windfalls.

For every Monster Beverage, however, there are countless failed businesses that never amount to anything or, even worse, outright scams that found a fertile breeding ground in the world of loose regulations and minimal reporting that defines penny stock trading. Never buy in response to cold calls or unsolicited pitches, insist on minimal financial reporting, work with a broker who doesn’t charge lots of fees, but most importantly, don’t expect to strike gold. Only invest in penny stocks what you can afford to lose, and balance the high risk of pink sheets with other, more stable investments.

This article originally appeared on GOBankingRates.com: How to Start Investing in Penny Stocks

This article by Andrew Lisa first appeared on GoBankingRates.com and was distributed by the Personal Finance Syndication Network.