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Are Inexpensive Stocks a Smart Choice?

Many consumers wonder about non-traditional ways to trade stocks. These approaches include activities like premarket trading post-market trading, the use of low-cost, or so-called “penny stocks,” and day trading. There are actually hundreds of unorthodox approaches for the venturesome but one of the most popular is the buying and selling of penny stocks.

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While definitions vary, most market experts consider any stocks that are priced below $5 per share to be penny stocks. Some investors and official publications use a cutoff of $3 or even $1 to define the category. However, the Securities and Exchange Commission’s definition is $5, so most investors view any share below that price to be a penny stock.

What are the pros and cons of trading these inexpensive instruments? Keep in mind that there’s a lot of emotion and misinformation about penny stocks. Some investors abhor them and consider them the bane of wise financial planning. Others view penny stocks as a smart way to purchase many shares of new, usually speculative companies. Not every portfolio is suited to this type of stock, but if you are among the millions of people who want to know the good and bad of penny shares, here are the facts:

Pros of Penny Stock Investing

You won’t need to fork over a huge sum of money to your broker in order to purchase a hundred or so penny shares. For many new investors and those who enjoy a bit of risk, this is the major advantage. The low initial cash outlay is a huge plus for those who want to get into the stock market but are discouraged by high-priced blue chips.

You can get as much or as little volatility as you like with low-prices shares. Many companies that sell below-$5-per-share stock are well-established and not very risky. Other penny-share companies are brand new and represent a big risk for anyone who buys in. That means you can calibrate your risk level by purchasing issues that are stable or quite volatile.

Potential gains can be significant. Because of the small initial price, if a penny stock rises by just 50 cents per share, that means the investor is reaping a 10 percent profit on every share of a $5 stock. When a $100 share of stock rises by the same 50 cents, that’s just a one-half percent increase. Penny stock enthusiasts often cite the massive potential gains as their main reason for falling in love with these low-priced shares.

Cons of Penny Stock Investing

Volatility is the big negative for investors. Penny shares tend to rise and fall much more than higher-prices stocks. Risk is high for new companies and for many other penny issuers. Consider the fact that most pension funds have rules prohibiting the purchase of penny stocks, and it’s easy to understand why some investors eschew these low-priced stocks.

Other Considerations

Penny stocks often disappear and become worthless as companies sink into financial trouble. Every investor should watch the company for several months before investing. Some brokerage firms either will not deal with penny stocks or will charge higher commissions if you want to add them to your portfolio.