The Risks of Buying Penny Stocks

A penny stock is a company that trades for less than $5 per share that doesn't trade on any of the major markets

. Investment strategies within this sector are highly marketed, but risk is rarely factored into the potential returns. Everyone is told that the stock market is the riskiest of the common investment strategies. Penny stocks are not included within the stock market strategy. They are an order of magnitude riskier than the common stock investment. The SEC requires brokers to show investors a sheet they produced which lays out the different risks of penny stock investing. So what specifically is so risky about penny stocks?

Not Understanding that Cheap is not a Deal

For some reason many think owning 3000 shares of a $1 per share stock is a better deal than 1 Berkshire Hathaway B Class stock at about $3000 per share. Investing in the stock market has nothing to do with how many shares you own, but what percentage the shares you own increase in value. If both stocks increase by 10% you've made $300 regardless of cheap stock or expensive stock. You need to understand the potential of growth for the stock from its current price.

The Values of Penny Stocks are Difficult to Determine

The SEC doesn't sanction these stocks so they don't spend effort validating the claims and controlling information about the penny stock companies. While they are still legally required to report to the IRS and maintain accounting books the auditing process is not as stringent on these smaller companies. Also, with billion dollar corporations the business can be valued by the books because things like cash flow, profit margins, and sales forecast have more understood and repeatable meanings. With a $25 million dollar company a single great idea can triple the value of the company or destroy it. One corrupt owner can bankrupt the company overnight while a billion dollar corporation would hurt, but be able to bounce back.

Volume Makes Trading Difficult

When you're trying to buy low and sell high it's hard to be successful when the stock just won't buy or sell. When trading volume is low prices on a stock can jump or fall more quickly. There has to be a buyer for a price to be set, no buyers and the price keeps plummeting. Low volume and market value also opens stocks to market manipulation. If the company is worth $25 million and the stock hits the news, a couple of million in investments at once will cause the price to skyrocket temporarily. There are people with this much money on their own just to adjust the price. Not all penny stocks have low trading volume, but there is no guaranteed trade executions like on the NYSE or NASDAQ. In some cases the trade volume is so low the price given on the stock is purely an estimate because there have been no trades that day.

Spread Makes Trading Expensive

The spread is the difference between what market makers are selling stocks for and what market makers are buying stocks for. When a stock is thinly traded this gap is high because the market maker has to ensure he will profit on the buy and sell transaction. Market makers are not investors, but businessmen. If the spread is 10% on a thinly traded stock, which is not necessarily high, the stock has to earn 10% before you even make a penny.

In conclusion penny stocks carry a higher risk to an investor. This risk is not only common knowledge, but recognized by the Securities Exchange Commission and should not be underestimated.

The Risks of Buying Penny Stocks

By: Lars Garrett

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