6 Reasons To Run From Penny Stocks

There’s the Republican vs. Democrat debate; the Apple vs. Samsung throw down and yes, the 'should you or should you not buy penny stock' controversy. Let’s take a look at why it’s probably in your best interest to stay away.

First, the term, “penny stock” is loosely defined. Some will say that its any stock below one dollar while an increasing amount of experts say five dollars. Many mutual funds cannot purchase stocks under $5 and most brokerages don’t allow shorting of stocks below $5. However, there’s no official definition of a penny stock.

Instead of looking at a certain monetary level, look at how the stock behaves. Zynga ZNGA trades around $3.35, but it’s difficult to call a stock trading 33 million shares daily a penny stock. With that in mind, let’s look at why it’s usually best to stay away.

1. It's cheap for a reason- Sure, everybody has to start somewhere, but anything priced for the bargain bin is usually that way because there isn’t much demand. That should raise a red flag regarding the quality of the potential trade.

2. It's hard to find good information- If there hasn’t been a news story written about the stock in months, no analyst is following it, and there’s a noticeable absence of data, it’s probably not worth your time. Why do a huge amount of digging to uncover the information when there are plenty of other stocks that have the data readily available? Nobody is saying to take a company’s word for everything but having data to evaluate is a big plus. And by the way, how will you know when something at the company changes?

Related: 7 Stocks For Your Retirement Portfolio

3. Might be hard to exit- Penny stocks are thinly traded. Some are so thinly traded that finding a buyer for your shares might take a lot longer than you expected.

4. The pump and dump- Somebody can find a penny stock that is thinly traded, purchase a bunch of shares, put together a bogus report saying that the stock is heading higher, send it out in an email blast and wait for the stock to bounce. Then, at its height, the person or people can sell their shares, then the stock would plunge and everybody who believed the report would lose their money. That’s a pump and dump.

Larger stocks have a much higher trading volume, making the pump and dump nearly impossible.

5. They’re volatile- If you think biotech stocks are volatile, try a penny stock. Don’t even consider buying into a low priced, low volume stock that is up 150 percent in the past month. Regardless of what you read or what somebody tells you, there’s no easy money in the stock market.

6. Technical analysis doesn’t work- Stocks with low volume don’t easily form reliable moving averages or chart patterns that come from higher volume. If you can’t make out any type of pattern, why take the risk?

But here’s the other side. If you’re looking at a cheap stock and it doesn’t fall into the above criteria, it might be a penny stock by price but not by behavior. If that’s the case, it might be worth a small nibble.

However, the stock market has thousands of choices. Every stock has risk but every great investor works to minimize the risk. It’s harder to manage risk when defining the risk is more difficult.