Investors looking to diversify their portfolios with smaller “penny” stocks in addition to higher-priced stocks on the traditional stock exchange need to know the basics of how penny stocks work. Penny stocks give investors the opportunity to buy shares of companies at very low prices—under $5 per share. Investors should carefully consider penny stocks before buying them.
If you’re looking to buy penny stocks, you need to choose a reputable brokerage for trading and go into it with a solid strategy. Since the price of penny stocks is so low, buying shares with a flat-fee brokerage rather than a per-share brokerage can keep your costs lower. However, penny stocks in general are a somewhat risky investment.
What are penny stocks?
Despite the name, penny stocks aren't priced at 1 cent per share. Previously, the SEC defined penny stocks as those priced under $1 per share. The definition has expanded to stocks trading below $5 per share.
Penny stocks are usually with companies of low or micro-market capitalizations. Most penny stocks trade in OTC (over-the-counter) markets instead of major exchanges like the Nasdaq and NYSE.
How to buy penny stocks
In order to buy shares of these smaller companies, you need to know where to buy penny stocks. There are several online brokerages that enable trading of penny stocks, but you want to pay attention to the fees they charge.
Flat-fee brokerages are a better option for penny stock trading because you only pay per transaction, rather than per share you buy. Fidelity, TD Ameritrade, Charles Schwab, TradeStation, and Interactive Brokers are some of the brokerage choices.
Stockbrokers.com points out that Interactive Brokers charges a per-share fee, which can increase your costs quickly when buying hundreds or thousands of shares of penny stocks. Fidelity, with no charge per trade, is a good option. TD Ameritrade and Charles Schwab might charge per transaction, but the flat fee is still preferable to a per-share fee.
Are penny stocks a good investment?
Penny stocks are generally considered a riskier play for investors, in part due to the lack of regulations. Smaller companies trading on OTC markets don’t usually have to report as much financial data or meet as many stringent requirements as larger companies.
Meanwhile, OTC stock trading has increased since the onset of the COVID-19 pandemic, in part due to the rapid rise of online brokerage platforms. Investors need to beware of scams and pump-and-dump schemes. In this case, someone boosts a stock’s price through misleading recommendations only to sell shares quickly at the higher price.
OTC stocks are coming under greater scrutiny. The SEC is working on a new rule to require more financial disclosures by companies, which could cause a thousand or more penny stocks to be delisted.
If you're considering buying penny stocks, be sure to do your own research into prospective companies beforehand. Create a strategy in which penny stocks are only a small percentage of your total portfolio in order to minimize risk. Avoid being manipulated by targeted advertising of certain stocks or online forums, which might hype up volatile stocks.