How to Invest in Penny Stocks for Beginners

For many beginner investors, the first logical stop is penny stocks. As the name suggests, penny stocks are those companies that trade with a low share price, often less than $1. It's understandable to see why rookies get hooked by the dream of buying into a company for only few cents and then selling for a substantial profit when the price trades back in the multi-dollar levels. The extremely low prices allow an investor to hold thousands of shares for a relatively small amount of invested capital. With that scale, the gain of just a few cents per share can translate into big percentage returns (the reverse is also true, of course).

But here's a fair warning: Such stocks are generally considered to be highly speculative and high risk for several reasons: their lack of liquidity, large bid-ask spreads (how much the ask price exceeds the bid price for an asset), small market capitalization, and limited following and disclosure.

Still, if you feel you are ready to start trading penny stocks, continue reading.

Understanding Penny Stocks

The Securities and Exchange Commission (SEC) defines a "penny stock" as a security issued by a small-cap or micro-cap company that has a market capitalization of less than $250 million. Others define penny stocks as those that trade at less than $5 per share (though some experts choose to adopt a lower cut-off value of $1 per share). They often have little or no financial history, or a bad one: The underlying company may be close to bankruptcy. Think of them as the opposite of blue-chip stocks, in short.

A penny stock usually trades off the major market exchanges. That's because the big stock exchanges, such as NYSE and Nasdaq, have listing requirements for the companies trading on them. Nasdaq will delist a company's shares if it fails to maintain a minimum closing bid price of $1 per share following 180 days. As a result, people interested in trading penny stocks often turn to the over-the-counter market (OTC). The OTC Markets Group organizes securities into tiered marketplaces that reflect the integrity of the operations, level of disclosure, and degree of investor engagement.

Narrowing Down Trading Candidates

Now that you understand where to trade penny stocks, the next step is to determine what stock to trade. One popular method is to use stock screening tools, such as the one found on the OTC Markets website or Finviz. Screening for stocks with a price under $1 is the easiest way to narrow down the trading universe. From here, you can filter the list down further depending on your strategy and risk tolerance. Maybe you are only interested in penny stocks that conduct business within the sector of drug manufacturing, for example. In this case, you’d make the necessary adjustments and then run the filter. 

Once you get the hang of using Finviz’s stock screener, your list, based on the filter above, should look something like this:

Source: Finviz.com | as of Sept. 11, 2021

Opening an Account

There are many factors to consider when opening a trading account, such as ease of transferring funds, fees, and customer service. Brokers specialize in different areas, so take your time to shop around for one that will meet your needs. For penny stock investors, one aspect to pay particular attention to is the fee structure. Some brokers charge commissions on a per-share basis. This structure is usually set at a certain rate for an initial number of shares, and then another rate for each additional share.

A per-share structure may be better suited for investors who are buying a relatively low number of shares and may not be the best for penny stock traders. It may prove more useful to choose a broker that offers a relatively low flat rate per trade, regardless of how many shares are involved. The lower the flat rate, the less impact that fees and commissions have on the final return.

Understanding the Risks

When it comes to trading penny stocks, it's extremely important to understand the risks involved. Since most institutional investors, such as mutual funds, index funds and money managers are prevented by charter from trading penny stocks, these equities generally lack a following in the investment community. Therefore, liquidity is a serious concern: It's not uncommon for retail investors to get stuck in a position for several days or weeks until there is enough supply or demand to enter or exit, experiencing serious price fluctuations along the way. With penny stocks, it is easier for traders to manipulate prices and make them look weak or strong.

The Bottom Line

When it comes to investing in penny stocks, tread with caution. In most cases, these companies are small-cap stocks and are susceptible to major volatility. If you feel like you understand the risks and are ready to proceed, the first step is to find a broker, fund an account, and then find a suitable trading candidate. Stock screeners are probably your best bet in narrowing down the universe of stocks so that you can find one that meets your trading style and risk tolerance.