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What Investors Should Know Before Buying Surging Penny Stocks

Shares selling for less than $1 sound like an alluring investment. But they come with serious risks such as exposure to pump-and-dump schemes.

What Investors Should Know Before Buying Surging Penny Stocks

Shares selling for less than $1 sound like an alluring investment. But they come with serious risks such as exposure to pump-and-dump schemes.

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Source: Getty Images

Little stocks are having a big week.

Six companies selling for less than $1 made up nearly a fifth of U.S. trading volume on Monday, according to data compiled by Joseph Saluzzi of Themis Trading LLC.

These included the likes of microcap company Zomedica Corp., which makes medicine for pets. Also on the list: Sundial Growers Inc., a Canadian pharmaceutical company that produces and grows a range of cannabis strains.

But hold on to your pennies before you start trading penny stocks. Financial advisers say that while such cheap shares have been performing well recently, they come with some serious risks.

Here’s what to know before you add to the billions of trades these shares have already seen this week:

What qualifies as a penny stock?

The U.S. Securities and Exchange Commission considers stocks that trade for less than $5 to be penny stocks. In the U.K., the general consensus is that shares going for less than 1 pound ($1.37) fall into this category.

Some penny stocks have made their way onto major indices including Nasdaq and the New York Stock Exchange. But most trade on marketplaces with less stringent financial-disclosure requirements. In the U.S. financial industry, they are called the “Pink Sheets” — a reference to the color of paper on which stock prices were printed before the days of electronic trading. Today, OTC Markets Group Inc. is one of the largest markets for these equities.

Scott Tindle, founder and director of Tindle Wealth Management in London, says that historically penny stocks may have been appealing because they allowed people to buy into companies without putting much down. These days though, the rise of fractional share trading has shaken up this dynamic.

Why the sudden interest?

Blame the internet. Mentions of some penny stocks in Reddit forums over the past few days have spurred huge jumps. TransEnterix Inc., which markets the Senhance surgical system, almost doubled on Monday, with trading volume more than 13 times normal. Zomedica, the pet-medicine company, was also mentioned frequently on Reddit.

Retail trading has boomed during the Covid-19 pandemic, with people stuck at home, often with more cash on hand than usual.

Scott Cole, president of Cole Financial Planning in Birmingham, Alabama, said a mix of dissatisfaction with returns elsewhere in the market, social-media mentions and just plain boredom are probably fueling interest.

What are the rewards?

Getting in cheap — literally for only a few dollars at most — can seem like a great investment strategy.

“The enticement is there because the stock prices are so low,” said Stephan Shipe, a financial adviser who owns Scholar Financial Advising LLC in Winston-Salem, North Carolina. “And with high risk comes the potential for high reward. Individual investors end up seeing a lot of this potential. They see someone earning 10,000% returns on penny stocks — or even just easily doubling their money — and that’s because it’s easy for a stock to go from 5 cents to 10 cents.”

How about the risks?

There are many.

“Probably one of the biggest risks you’re dealing with is the size of the companies in general,” Shipe said. Because their underlying firms are so small, penny stocks tend not to have the protections of blue-chip stocks.

Small firms tend not to issue a lot of shares, either. This can make it difficult to sell your shares or exit your position later, Shipe said.

Colin Moynahan of Twenty Fifty Capital in Charleston, South Carolina, worries about exposure to risks such as “pump and dump” schemes.

“It’s marketing meets finance,” Moynahan said. In social media, chat rooms or forums, people can push a lot of positive news about a potential cheap stock. This drives interest, trading volume and price.

“They may find some facts to support their hypothesis, but at the end of the day all they’re trying to do is bring in that trading volume, increase it, and then they get out before any of the followers,” Moynahan said.

And if you still want to get in?

It’s possible to buy penny stocks on traditional trading platforms. Although he wouldn’t recommend it, Moynahan said that investors who are dead-set on getting in should do their homework. He urges people to ask themselves of these stocks: “Why all of a sudden are they a hot company?”

If there isn’t a lot of information on why the firm might be profitable, steer clear, he says.

Cole, of Cole Financial Planning, said it’s fine to bet on penny stocks. But he would consider it that: betting, not investing.

“Just make sure you can afford to lose every cent and have hard rules about what governs your speculation,” he said.