As the name suggests, penny stocks are stocks that are extremely cheap, usually priced less than $5 a share. These are most commonly all from small companies. These stocks are traded on the Over-The-Counter-Bulletin-Board (OTCBB) and the Pink Sheets. Both these trading venues do not have the same kind of minimum requirements of exchanges such as Nasdaq or the NYSE set by the Securities and Exchange Commission. Companies that issue penny stocks may be new businesses or close to bankruptcy. So beware when you are investing in such stocks - keep in mind that some of these companies are startups and others are near bankruptcy.
1. A Bad Investment
In fact, the low price may be the only thing that penny stocks have going for them. A lack of standards and stability make penny stocks one of the riskiest investments around. It is true that if a company succeeds the payoff will be great, but the vast majority of penny stocks end in utter failure.
2. Lack Of Company Information
Companies listed in the Pink Sheets or the OTCBB do not have to issue financial statements. Most companies also have little reportable history that is known. You certainly will never have heard about any of these companies, nor will they be likely to have ever been featured on the news.
3. Low Liquidity
Very infrequently traded, finding a buyer once you invest can be a real hair puller. You may have to lower your price a lot in order to get people interested enough to take the stock off your hands.
4. Fraud
Because they are completely unregulated, penny stocks are commonly used by con artists who sell them through spam emails or off-shore brokerages that don't have to adhere to laws because they operate in international waters.
5. Why On Earth Choose Penny Stocks?
All of this doom and gloom might have you wondering why you should consider penny stocks at all! Well, first of all, not all penny stocks are frauds or companies facing bankruptcy. Some represent hard-working businesses that are struggling to meet the requirements to get listed on Nasdaq or the NYSE. Investing in these companies offers real growth potential, you have the opportunity to get in at the ground floor and ride all the way to the top. The difficulty is finding that companies have this growth potential. Getting this information requires a lot of research and unless you are willing to take the time to personally investigate a company, you may as well throw in the towel.
Most so-called experts of the stock market always tell traders to buy the blue chips stocks and build a portfolio. They tell you to buy stocks like Wal-Mart, Exxon, etc... The problem with that is that most new traders to the market don't have a $100,000 to invest and build a portfolio full of Microsofts.
To give you an example, lets say that a new trader wants to put in $3,000 into the market. Do you really think they would be able to build much of a portfolio investing in the companies that most analysts recommend? Probably not. They'll be lucky to buy 100 shares of just one of those stocks.
Now, take a look and see how far that money would stretch if the trader just traded penny stocks. They would be able to buy 7500 shares of 25 cent stock. They could even take that money and invest it in an all-penny stock portfolio.
That's the amazing thing about leverage. You're able to get more shares of more stocks and your risk to reward ratio is so much better than if you traded the blue chip stocks.
What kind of return could you possibly expect to get from stocks like Target or Microsoft? It won't be a whole lot more.
These are just the kind of companies that are fully grown. There is a cap to how much they can potentially grow from this point on. People invest in these kind of stocks and hope to get a return of 10% year, if they are lucky.
But when it comes to penny stocks, they have all the room in the world to grow. Some penny stocks have increased in price by as much as 400% in one single day. It's really not strange for an unknown company to suddenly become the stock market's new darling.
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