How to Find and Invest in Penny Stocks

Investors with high-risk tolerances often turn to penny stocks, which are defined as companies trading at a share price below $5. But as their name suggests, such stocks may trade for less than $1, allowing investors to hold thousands of shares for relatively small amounts of capital. And when the price spikes to multi-dollar levels, investors stand to gain handsomely.

But such stocks could just as easily fall to zero. Not surprisingly, penny stocks are generally considered to be highly speculative because of large bid-ask spreads, small market capitalization, and lack of liquidity. This article details guidelines to help investors navigate the often thorny penny stock minefield.

Penny Stock Platforms

To trade on major stock exchanges like the New York Stock Exchange and the Nasdaq, penny stocks must satisfy a multitude of special listing requirements. For example, according to Nasdaq Rule 5550(a), equities must maintain a minimum bid price of $1 per share. Consequently, literal penny stocks that cost under $1 per share are primarily traded on the over-the-counter bulletin board (OTCBB) and through the Pink Sheets, which is merely a quotation publisher. And due to the fact that Pink Sheets stocks are not registered with the SEC, they’re inherently riskier investments.

Selecting a Broker

When shopping for a penny stockbroker to execute trades, their fee structures demand thorough consideration. Brokers who charge commissions on a per-share basis are not the best choice for penny stock investors who purchase large amounts of shares. Contrarily, brokers who charge flat fees make greater fiscal sense. Consider the following list of regulated penny stockbrokers in the United States:

• ChoiceTrade: ChoiceTrade trades penny stocks on the Over the Counter Bulletin Board (OTCBB) and Pink Sheet markets, and offers two distinct plans. Stock Plan-A customers receive commission-free stock trades, while Stock Plan-B customers pay $5 stock trades. For all other trades, ChoiceTrade charges a $7 flat fee. An additional $0.0007 per share charge applies to shares over 10,000.
• Charles Schwab Corp: Schwab offers penny stocks trading through its standard stock trading accounts, where one can trade Over the Counter Bulletin Board (OTCBB) and Pink Sheet securities online through the Schwab website and mobile app. The penny stock brokerage charges are $4.95 per trade.
• Scottrade: Scottrade offers penny stocks trading at a flat base rate of $6.95 per trade, plus 0.5% of the trading principal on stocks under $1 per share. Scottrade offers research and screening tools, including real-time quotes, advanced stock screeners, market news, and analyst reports.
• TD Ameritrade: (AMTD) accepts orders for penny stocks listed on OTC Bulletin Board and Pink Sheet securities. These can be traded through the standard equity trading accounts offered by TD Ameritrade. The standard brokerage charges of $6.95 per trade apply to penny stocks.

Charges and More Charges

Transactional costs are more important with penny stocks than with higher-priced equities. Let’s assume you intend to buy a penny stock currently trading at the current market price (CMP) of $0.10 per share, and you expect the price to double to $0.20 for a quick and tidy gain. If a broker’s commission structure effectively charges you $0.05 on each buy and sell leg of your trade, the profits are effectively erased. For this reason, it’s vitally important to consider fees, before signing on with a given broker.

Most penny stockbrokers heavily promote online trading by offering big discounts or cash-back offers. But it’s vitally important to read the fine print and learn the following points:

• Is short selling allowed? Although short selling may be bound by regulatory requirements, some brokers disallow short selling in penny stocks, as an additional self-imposed risk management measure. Those allowing short selling may need to maintain higher margins.
• Is there a delayed website response time and a long telephone hold time? Due to the high volatility associated with buying and selling penny stocks, traders may experience jarring price changes in the mere minutes they’re waiting to execute trades.
• Does the platform offer built-in tools? Traders who require access to dedicated research tools, streaming data feeds, and technical indicators needed to make trading decisions should be aware of the potential extra costs of these special features.

Avoiding Penny Stock Scams

Investors who are promised high returns for low costs should be on the lookout for the following red flags, in order to avoid fraudulent deals:

• Unofficial internet/email promotions
• Promotions brokers offer through boiler room telemarketing calls
• Vaguely-labeled newsletter and online forums touting so-called "hot tips."

Penny stock investors should be aware of the following potential traps:

• Pump and Dump schemes: This is when promoters claim access to insider information in their efforts to inflate the prices of earlier purchased low-cost lots, that they subsequently attempt to offload for high profits. Gullible investors who act on these tips may end up saddled with high-cost investments that they'll have trouble unloading.
• Short and Distort: This is a variant of pump and dump, essentially working in the reverse direction. Promoters short sell penny stocks at high prices and then promote negative news about the stocks in a strategic effort to lower the prices and square off their positions for high profits.
• Long-term averaging techniques: A cyclical scheme where investors are advised to continue accumulating a penny stock with each price dip, with assurances of windfall profits once the stock prices take a positive turn.

The Bottom Line

Penny stock investing can be precarious and isn’t for everyone. But those who are willing to stomach the risk should first find a broker, fund an account, and pay vigilant attention to pricing moves. Careful investors who steer clear of fraudulent deals may see substantial profits in the future.