If you have ever watched Martin Scorcese’s The Wolf of Wall Street, then you’ve heard of penny stocks at least once. These security options are what infamously helped Jordan Belfort launch his controversial career as a Wall Street mogul–and led him into jail.

Depending on who you talk to, penny stocks might be a way to get rich or lose money. Either way, no one can deny that the idea of trading stocks that aren’t worth much sounds like fun. What if a low-cost investment turns into a huge payday? This is the kind of thinking that makes penny stocks so appealing to the new investor.

We talked to investor and banker Justin Furniel to try to develop a comprehensive understanding of what exactly penny stocks are when you should invest in them and the possible downsides to this type of security. We learned that all that glitters is not gold, and if you’re interested in penny stocks, you have to learn about the pitfalls they come with.

What Are Penny Stocks?

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“Penny stocks in the past were defined as any stocks that traded for less than one dollar per share; hence the name penny stock,” Furniel explains. “However, the U.S. Securities and Exchange Commission (SEC) later modified the definition to include all stocks trading below five dollars.”

The penny stock market is volatile–a term that implies the statistical measure of the dispersion of returns for a security or market index. A volatile market means more risk, while a market with low volatility is considered safer. The penny stock market has many stocks that frequently change in value, making them more volatile.
Volatility can also lead to companies using penny stocks in shady ways. For example, folks who aren’t educated on how penny stocks work can easily be led to believe that because you can so easily purchase a large number of low-cost stocks, you’ll make a profit more quickly, too. However, that’s not true. The low prices of penny stocks do not correlate with strong returns.

“Penny stocks are often found quite attractive to individuals who are new to the trading world simply because they are cheap to purchase,” says Furniel. “However, cheap is not always congruent with making a great investment. This is because although the price of a penny stocks may be cheap, it does not guarantee that it is an investment that will appreciate into a large company with an established track record like Apple ($AAPL).”
Thus, investors should be wary when dealing with penny stocks. New investors especially must be careful about falling into the appeal of a low-cost penny stock. Many investors get mixed up financially when they start believing penny stocks are an easy avenue to riches.

Why Penny Stocks Exist

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You might be wondering why penny stocks exist at all. What’s the benefit of offering such a low-cost option to the public?

“A majority of the time, penny stocks are issued from companies that are struggling to grow,” Furniel says.

This is also the reason that penny stock prices tend to trend downward.

“Although penny stocks are often birthed by small companies that rarely appreciate, there are sometimes a few companies that start off as penny stocks and later grow into large established companies, like Advanced Micro Devices ($AMD), which traded for five dollars per share back in June of 2016. They broke past $95 per share in December 2020.”

Penny stocks do have the potential to create good returns, and companies that start by offering penny stocks might grow the way Advanced Micro Devices did. On the flip side, though, there are situations where the opposite can happen.

“Generally, penny stocks are created by small companies and startups that issue shares of the company to raise capital to grow the business through an initial public offering (IPO). However, under rare conditions, former large companies can sell off massively and become a penny stock as well.”

Companies That Were Once Penny Stocks

Although it doesn’t happen too often, it’s very notable when a company grows from penny stocks to big business. It’s also good to realize that all companies can slip into penny stock territory if their value dips enough.

For example, Ford Motor Company has been a penny stock before. Sirius XM satellite radio has spent much time as a penny stock, despite how popular the business is. Xerox is an example of a company that fell into penny stock territory after new technology made its innovations obsolete.

Monster Beverage Corp. has also been in the penny stock club, and so has the smartphone company BlackBerry. No matter how big a business may seem, seeing stock values plummet can humble the heads of their operations very quickly.

The good news is that these companies can often rebound over time if investors who believe in them continue to buy the stocks.

How to Invest Carefully

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The best way to exercise caution when dabbling in penny stocks is to be as informed as possible about how risky and volatile they are. Investors can definitely see gains from penny stocks, but they aren’t easier to profit from than regular stocks. They require just as much investment finesse and strategy as the rest of the market.

“Penny stocks often have a lack of liquidity or ready buyers in the marketplace, which as a result makes it difficult to sell stock since there may not be any buyers at that time,” Furniel says. “Due to their lack of liquidity and small company sizes, penny stocks are generally considered highly speculative, making it difficult to find a price that accurately reflects the market.”

When it comes to investing, the term “speculative” is used to describe an investment as very risky. When an investor wants to purchase a speculative investment, they are usually doing so because they believe the price will fluctuate to a better position.

Basically, investing in a speculative option is not about the value of the stock at the time. The investor’s hope is that the price will move so that they can sell the investment later and make big bucks. This applies to penny stocks because those who invest in them are hoping to see big returns on their low-cost purchase.

If you find a penny stock that interests you, make sure you do as much research as possible on the company. Penny stocks don’t always have to file documents with the SEC that offer transparency about the company that most stocks must submit. Thus, companies offering penny stocks don’t have as much information out there that can help you decide if they’re worth your investment. You have to take the research into your own hands to make sure that you’re not being swindled.

The Potential for Reward

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Penny stocks can indeed be a wise investment choice. However, they are typically favored by traders over investors on the market. Traders like that penny stocks offer them a quick profit–if they do it right.

“When adding in the factors of low prices mixed in with low liquidity, this creates a condition of high volatility, resulting in a higher potential for reward and, thus, a higher level of inherent risk,” Furniel says. “For example, if a penny stock is trading at 50 cents per share and then goes up to one dollar per share, this is a gain of 100%, despite the price difference only being fifty cents.”

Keep in mind that the potential for reward is decent for those who can make these investments strategically. It’s not easy, and people stay away from penny stocks for that very reason.
“This is why penny stocks are often avoided by investors and targeted by traders because as an investor you are looking to purchase assets at a deal with an expectation of a larger return, while a trader is simply trying to profit in the short term and take advantage of the price fluctuations to hopefully make a profit.”

Remember too that penny stocks are volatile because they’re susceptible to being used in scams. A well-known type of securities fraud is called a “pump and dump” scheme. If someone can successfully market stock as an excellent investment, they can push it onto buyers who don’t realize the price is being driven artificially. The heads of the scheme will continue driving up the stock’s price with misleading or false statements about the stock’s actual value.

When enough investors buy the stock, the heads of the scheme will sell all their shares. This is the “dump” part of the equation. They will profit from the investors they swindled into buying that stock, leaving the investors to lose all their money.

Jordan Belfort founded Stratton Oakmont in 1989. The brokerage house quickly began a pump-and-dump scheme and defrauded their shareholders, ultimately leading to Belfort’s incarceration.
At first glance, penny stocks may seem harmless. However, you must do your research before investing in them. If the deal looks too good to be true, there’s a chance it might be.

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