Penny Stock Investment Limits

Brokerage Restrictions

Most brokers put special limits on stocks trading below $5 a share. You may find exceptions, but most brokers do not allow you to sell a stock short once it drops below $5. In addition, most brokers do not allow you to trade penny stocks using margin. This means you cannot borrow money from your broker to buy stocks in this class. Finally, penny stock transactions can be more expensive, because many brokers assess extra fees for buying them.

When a company's share price drops below a dollar, it typically is delisted from all stock exchanges and is sent to the over-the-counter (OTC) market. Exchanges have strict company reporting requirements and other restrictions in place designed to protect investors. The OTC market is like the wild west of the stock market--almost anything goes. Thus, penny stocks are more prone to various types of order manipulation, and less investor information is available for these companies, increasing their risk to investors.

The 2000 film "Boiler Room" put the unscrupulous, and illegal, pump-and-dump in the public spotlight. Penny stocks typically have very low transaction volume. As a result, a relatively small amount of money can drive their price sharply higher. Unscrupulous traders may buy penny stock shares quietly at a low price and then hype the prospects of the stock to potential investors. Once the price is high enough, the trader sells his shares, leaving investors with a big loss as the share price drops again.

Many penny stock buyers are victims of a fallacy. They believe shares for companies such as Microsoft and Walmart once traded as penny stocks. As a result, they believe finding the next big thing is a matter of discovering the right penny stock. Most major companies did not start from the gutter, however. Microsoft, for example, debuted at $21 a share. The vast majority of penny stocks are either underfunded upstarts or companies undergoing bankruptcy proceedings. They are cheap for a reason.