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- Penny stocks are securities that trade at less than $5 per share, often in unsupervised over-the-counter (OTC) markets.
- Penny stocks are considered lucrative but high-risk investments: volatile, illiquid, and often subject to scams.
- Investors interested in penny stocks should deal with those listed on larger exchanges and sold by established brokers.
Penny stocks have become more popular than ever, tempting investors with a low cost of entry and the prospect of significant financial gains. Stories of shares making gains of over 4,000% in just months add to their appeal, and new trading technology makes it easier than ever to enter the market.
But while they can be lucrative, penny stocks come with significant risk. Potential investors should be careful to understand what they're getting into.
What are penny stocks?
Penny stocks refer to company stocks that cost, if not merely a penny, a pretty low amount. In the US, the SEC defines them as those that trade for less than $5 per share. Because they're often sold "over the counter" (OTC), rather than in centralized stock exchanges, they are also sometimes called OTCstocks.
Depending on the issuing company's market capitalization — the total dollar value of its outstanding shares — penny stocks can be referred to as small-cap, micro-cap, or nano-cap stocks.
Understanding how penny stocks work — and how they're traded
Penny stocks are usually issued by new or very small companies. These companies often don't have the kind of track record that generates investor interest, which is why their shares are sold for so little. Larger, more established companies may also have stocks trading under $5 when they are facing financial trouble or approaching bankruptcy.
Some penny stocks are listed on major exchanges, like the New York Stock Exchange (NYSE).
Much more often, however, they are traded over the counter, through a network of brokers and dealers, rather than on a centralized market. The OTC Link LLC and OTC Bulletin Board are two of the major exchanges for penny stocks.
Pros of trading penny stocks
1. Penny stocks are cheap
You would have to spend thousands of dollars to get a lot of shares of Facebook or Google — if you were buying full shares and not fractional shares — but you can spend a lot less to get in on the penny stock market. The idea of buying shares of a solid startup at $0.20 and cashing out at $1 — or even much more — is tempting to many investors.
2. You might get into a profitable company on the ground floor
It's every investor's dream: Catch an unknown star before it gets discovered, and ride it when it starts to soar. Strange as it sounds, Amazon (AMZN) was one such at one point. Back in 1997, you could buy Amazon shares for $1.68; as late as 1998, you could get them for $5. Amazon is currently trading for a lot more than that now.
3. Trading can be thrilling
Penny stock trading can be fast and furious. "So when they move 20%, 50%, or even 100%, they often produce gains within days or hours, or even within minutes," says Peter Leeds, author of "Penny Stocks for Dummies," adding, "that's a lot more exciting than you will ever see from any big-name stocks like IBM or McDonald's."
Cons of trading penny stocks
1. The companies are obscure, troubled, or untried
Being unknown can be a good thing. As noted above, Amazon was an obscure company at one point.
Most companies do not perform as well as Amazon. The vast majority of obscure, troubled, or untried companies are not great investments. Many penny stocks are in hot industries — like cannabis or info-tech — but that doesn't mean the individual firm is a winner.
2. Volatile prices
Volatile prices can deliver huge gains to investors. But they can also deliver massive losses. Those 20% to 100% price moves aren't always in an upward direction. The SEC warns that penny stock investors "should be prepared for the possibility that they may lose their whole investment."
3. Illiquidity
Liquidity refers to how easily securities can be sold. Stocks can be characterized as less liquid when it's not easy to sell them without taking a loss. Since relatively few people trade in penny stocks, it can be hard to unload them, even when — especially when — they start to drop.
4. Lack of transparency and information
There tends to be less information available on companies in the penny stock market than there is on other securities markets.
Companies trading on the large, centralized exchanges file their financial reports to the SEC, which are available to investors for free. Until September 2020, these reports were not required of companies issuing penny stocks.
The SEC has recently issued new rules to increase information and improve investor protections. Brokers are now prohibited from quoting a price for a penny stock unless the issuing company has publicly released its current financials.
So there is a movement toward transparency. Still, up-to-date and unbiased information on a penny stock can be hard to come by, and often no regulator is demanding or evaluating a company's filing.
5. High risk of fraud
The lack of information and transparency is one reason that fraud is so common in the penny stock market.
One common scheme is called the "pump and dump." Scammers purchase huge quantities of a stock and then share misleading information to make it attractive to other investors. In some cases, individuals even create fake shell companies that do not actually do any business or have any assets.
Believing that the stock is a good investment, investors buy shares, causing the price to rise. The scammers then sell off their shares, earning huge profits and causing the share price to collapse. Investors are then left holding worthless stocks.
Penny stock investing tips
If you're still game to play penny stocks, bear these thoughts in mind:
- Buy only the best. Look for very high-quality companies with rock-solid balance sheets. Make sure you can find up-to-date financials or analyst reports so you can make well-informed decisions.
- Avoid "grey markets." Companies trading on the large exchanges, like the NYSE and Nasdaq, have to follow strict regulations to be listed, as do those on the OTC Markets Group. But avoid other OTC exchanges, like the OTCQX®, and the OTCQB® markets. They're commonly called "grey markets" because their lack of listing requirements attracts less legitimate companies that have a higher risk of fraud.
- Use established stock brokers. Make sure any broker that you use follows the SEC's rules. They should be willing to provide you with written research about the investments they're promoting.
- Do your own research. The way to avoid scams is to research companies thoroughly. Don't trust unsolicited emails, chatrooms, or cold calls. Instead, contact your state securities regulator or the SEC to get accurate information about a company you're interested in.
- Invest only what you can afford to lose. Don't put all your eggs in the penny stock basket. It can be a good play with any disposable income you may have, but this isn't the place to invest your retirement savings.
Ultimately, it's always a good idea to do lots of research to better understand the ins and outs of investing in penny stocks.
The bottom line on penny stocks
Trading in penny stocks is not for the faint of heart. Successful investors tend to be experienced and have a sophisticated understanding of the field.
They've often developed comprehensive methods of analysis to be able to distinguish between a good deal and a scam. And they can devote a lot of time to trading and watching the fast-moving market.
If you're new to investing, trading penny stocks is probably not the right place to start. But if you're confident that you understand the risks, that you can find an honest broker, and that you're able to spot a legitimate but undervalued company, it could work for you.
You might even find the next Amazon.
Ramsay is a freelance writer and data analyst atCrisp Analytics. He has worked in the Office of the Chief Economist in Canada's Department of Trade, and has advised on the financial chapters of First Nations treaties when he worked with Indigenous and Northern Affairs Canada. He has a Master's in Public Administration from the University of Victoria and a certificate in Data Science and Big Data from the Federal University of Paraná.
Senior Editor, Personal Finance Insider
Jasmine was a senior editor at Insider where she led a team at Personal Finance Insider, focusing on explainers, how-tos, and rounds-ups meant to help readers better understand personal finance, investing, and the economy.Her team tackled projects including:• Women of Means, a series about women taking control of their finances.• Better, Smarter, Faster, a series that reveals the impactful choices you can make with your money to set yourself up to pursue your passions and fulfill big life goals.• Master Your Money, a yearlong guide for millennials on how to take control of their finances.• Rethinking Retirement, an editorial collection with stories that will inspire and provide the foundation for planning a different type of future than the 9-5 life allows.• The Road to Home, a comprehensive guide to buying your first house.She also worked cross-functionally with the video team at Insider to develop and build PFI's YouTube channel.Before joining Insider, she was a senior editor at NextAdvisor, Time magazine's personal-finance brand launched in partnership with Red Ventures. Before that, she was an editor at Credit Karma.
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