Dear Kirk:  Are penny stocks a legitimate way to make money? How do they work?

Kirk Says:  Let’s start our conversation around “penny stocks” by defining the term. A penny stock is a share of a company that usually trades between $0.01 to $2.00 per share, but technically there are no set rules dictating that they have to be traded in this range.

Another characteristic of penny stocks is that they are very price volatile, often have small market capitalizations and make little to no profit. Therefore even for the experienced investor, these stocks are a land mine waiting to blow up in your face. Because of their low cost per share and the possibility of a quick return if their price moves up just a couple of pennies, they create the illusion of a worthy investment.

Other risks associated with these stocks are the relatively large ask/bid spreads and illiquidity that can make it difficult to enter and/or exit the position.

Let’s put some real numbers to this scenario. Let’s say shares of an unnamed penny stock have traded between $0.16 and $0.36 over the last 52 weeks. A savvy beginning investor might say to themselves, “If I bought in at $0.16 and invested $5000, then I could have possibly made $11,250—over 100 percent profit if I was able to sell at the high of $0.36.”

However, the devil is in the details.

The average trading volume over the last three months has been 7,883 shares per day. So it would have taken you four trading days to purchase all of your shares at $0.16 (a price you may not have been able to actually get). And then on the flip side, when you decide to sell those shares, it would take roughly another four days to execute the sell trade, making it difficult to get that ideal $0.36 per share for all 31,000+ shares.

In conclusion, penny stocks are more akin to playing the penny slots in Las Vegas than they are to being a disciplined investment program. For the beginning investor, start with a good growth mutual fund. Spend time gaining experience watching the mutual fund positions and the ways that the portfolio managers make decisions based on sound business fundamentals about which stocks to buy and sell out of the portfolio. Then, if you want to try your hand at individual stocks, look for large cap companies and start with small blocks like 100 shares.

Good luck, and happy investing!

Kirk Gwaltney is a Chartered Financial Consultant and a Chartered Life Underwriter in Brentwood, Tenn. Learn more about him at kirkgwaltney.com.