An Introduction to Penny Stocks

Not every investor has the money or inclination to invest in large, well-established companies that will eventually provide gains. Some may be looking for short-term explosive growth; others may just want to see any return on investment in a few months, rather than waiting out the market. This is where penny stocks come into play.

Penny stocks, also known as microcap stocks, are stocks offered by a small company for less than $5 per share. Most investors like penny stocks. This is because they have a high potential for sudden and explosive growth. And that leads to high return on investment (ROI).

However, these returns are not guaranteed. In fact, a result of the fundamental makeup of penny stocks, they’re considered “speculative” – investments that carry a high risk. This risk is often equivalent to or greater than their growth potential. Which is why it’s essential to understand these types of stocks before you invest.

TL;DR

Penny stocks are named this because they used to trade for pennies apiece. They are stocks that allow issuing companies (typically small-cap organizations) to raise capital without meeting stringent requirements of large exchanges. As with “regular” stocks, penny securities are created through an IPO. Although the company doesn’t always have to file a registration with the SEC.

These stocks are not classified in the same way as large stocks. But there are three basic ways to examine them:

  • Based on business structure and fundamentals
  • According to their volume
  • Based on their history of volatility

Typically, penny stocks trade over-the-counter rather than on large exchanges. Although there are a few (as well as “low price” securities) that trade on nationwide exchanges. These include as the NYSE and Nasdaq.

Penny stocks are known for the volatility and high risk, as well as for their potential for high reward. It’s usually advised an investor be in a high risk tolerance bracket to invest. However, if an individual believes they can stomach losing everything, there can be massive financial gains.

Explaining Penny Stocks

The term “penny stock” used to apply to stocks that traded for less than one dollar apiece. Hence the name. These stocks traded for literally pennies. However, the SEC (Securities and Exchange Commission) has since adjusted the definition. Now it’s any stock trading at five dollars or less per share.

The purpose of a penny stock is to provide small companies with a way to raise capital via public funding. This move is often the first big step for small companies growing in their industry. It can provide the impetus needed for smaller players to build their presence with the public.

Companies create penny stocks through the IPO, or initial public offering, process – just like larger companies. They are required to follow all applicable securities laws in the state or country in which they list. Furthermore, before going public, the company much register with the SEC or explain why they’re exempt from registering.

Once a company has been approved to trade penny stocks, it can apply to list with various boards and exchanges. Typically, these stocks trade through over the counter (OTC) transactions. This is done via the OTC Bulletin Board (OTCBB) or Pink Sheets (a private trading board).

However, some companies may offer penny stocks in private transactions as well. Furthermore, some of these stocks meet the listing requirements for exchanges such as New York Stock Exchange (NYSE) or the Nasdaq. They are traded on par with the big guys.

Due to the lax process and requirements for listing penny stocks, they come with high risks that offset potential rewards. Understanding these risks is paramount to successfully selecting a “winner” in the penny stocks game.

The Risks of Penny Stocks

For the most part, penny stocks are issued by smaller or newer companies. Therefore, one of their hallmarks is the fact they frequently have both low liquidity and low buyer numbers. This leads to infrequent trades.

Penny stocks are also more volatile than securities offered by larger companies. It’s easy to see why, too. A $4 move on a $5 penny stock is a much bigger deal than a $4 move on Amazon’s shares. Furthermore, as investors frequently purchase these stocks in bulk, large orders by a single individual can drastically increase or drop the price on a dime.

Additionally, as penny stocks are also available for after-hours trading, the volatility does not end at the close of the trading day. Some investors prefer to wait until after-hours trades due to the potential for selling shares at unusually high prices (or buying them at extraordinarily low prices).

However, due to the aforementioned limited liquidity and interest, investors may be unable to find a buyer – or a fair price – when it comes time to shed their investment.

There are a few other risks associated with penny stocks that are not usually present (or at least not as prevalent) in larger stocks. Some of these include:

  • Wide bid-ask spreads (large price quote variations)
  • Lack of legally mandated public information
  • No minimum requirements to list on a trading board
  • High fraud potential

Additionally, many penny stocks are issued by either smaller companies or large companies that have a poor track record. Some of these companies may be heading for bankruptcy, while others may list these stocks under false pretenses in an attempt to grow their capital.

Therefore, as a rule, penny stocks are best suited for investors with a higher risk tolerance. This group is typically defined as younger investors (or investors with deep pockets).

Many advisors also recommend that, regardless of financial status, investors place a “stop-loss order” with their broker. The purpose of this decree is to automatically sell a particular security when the price drops below a specified threshold. This move minimizes both loss and risk for investors.

When is a Company Not a Penny Stock?

Aside from being worth more than $5 per share, there are a few situations in which stocks trading for pennies are not, in fact, penny stocks.

This is due to the limited regulations that define penny stocks, as well as the more encompassing regulations that deal with large securities. In order to be a penny stock, a company must meet certain criteria, such as shareholder equity and market capitalization in addition to price.

Perhaps most importantly, securities on a national stock exchange are typically exempt from designation as a penny stock, in large part because securities on large exchanges are thought to be more resistant to manipulation and fraud. Therefore, when stocks crashed in 2008, and again during the 2020 pandemic market, large companies that fell below the $5 threshold were not reclassified as “penny stocks.” Instead, these companies were labeled “low price securities.”

Different Types of Penny Stocks

There are three main ways to differentiate and research penny stocks that the average investor should be aware of. While these are not “official” classifications, they provide a basic framework for examining the penny stock market.

Solid Business Structure and Fundamentals

Examining a company’s business structure and their financial fundamentals is a good way to get a feel for the organization and growth potential. Especially with penny stocks, a solid business structure and potential for growth can outweigh some of the risks. However, if companies offer little to no information, or all of the information that is available makes you balk, you should be wary of investing your capital.

For instance, companies with a history of low financial metrics plus low growth are rarely a good buy, as their room for expansion is overshadowed by poor performance. On the other hand, if a company currently has so-so numbers but a history of upward momentum, the stock may be ready to make that coveted price leap.

High Volume

Some penny stocks are historically known for their high-volume trades. While this is one of the reasons these stocks are volatile, it’s also part of what makes them so profitable. Furthermore, if a penny stock has a history of trading on larger volumes, it will be easier for an investor to find a buyer when they’re ready to get out.

High Volatility

Whether you’ve been in the game for years or are just getting started, knowing any security’s volatility and price history is important before buying in. As a rule, stocks with stable prices are low-volatility, while stocks with erratic leaps are high-volatility.

While volatility can be dangerous, it can also reap large rewards. The key to investing based on volatility is to consider whether the stock in question has a general history of upward trends or sudden leaps, rather than a history riddled with extreme dips and only moderate gains.

Why People Invest in Penny Stocks

With all of the risks and potential for manipulation inherent in the penny stock market, some people may be asking – why would anyone want to invest?

The answer is actually the same as to the question of why investors wouldn’t want to invest in them: their volatility.

Because penny stocks are prone to such large leaps overnight or in a matter of weeks, many investors believe that by choosing the right stock at the right time, they can cash in on sudden gains. While companies rarely make a sudden leap from penny stocks to “normal” stocks, it’s happened before – and the investors who rode the wave to the top made a pretty penny doing so.

However, success in penny stocks involves choosing the right one, and sometimes holding out through drastic dips that make normal investors quake with fear. Once more, it’s recommended that investors don’t dive into these stocks unless they have a higher risk tolerance.

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