What Is a Penny Stock?

A penny stock typically refers to the stock of a small company that trades for less than $5 per share. While some penny stocks are listed on major exchanges like the New York Stock Exchange (NYSE), the majority are traded over-the-counter (OTC) via platforms such as the OTC Bulletin Board (OTCBB) or OTC Markets Group.

Unlike traditional exchanges, OTC transactions have no physical trading floor, and quotes are done electronically.

Key Takeaways

• A penny stock refers to a small company’s stock that typically trades for less than $5 per share.
• While some penny stocks may trade on major exchanges like the NYSE, the majority trade over-the-counter through platforms like the OTC Bulletin Board (OTCBB).
• Trading penny stocks can yield significant gains, but investors should be aware of the high risk of losing a substantial portion of their investment in a short period.

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Understanding Penny Stocks

In the past, penny stocks were defined as stocks trading for less than one dollar per share. However, the U.S. Securities and Exchange Commission (SEC) has expanded this definition to include stocks trading below five dollars. As an independent federal agency, the SEC safeguards investors and ensures the orderly functioning of securities markets.

Penny stocks are often linked to small companies with limited liquidity, making it challenging for investors to sell shares at fair market prices due to insufficient demand. This lack of liquidity also makes penny stocks highly speculative, posing a risk of significant investment loss.

Due to factors like low liquidity, wide bid-ask spreads, and small company size, penny stocks are generally considered highly speculative, and investors are cautioned that they could lose a substantial portion or all of their investment.

Penny Stock Volatility

Penny stocks often represent growing companies with limited financial resources, making them more suitable for investors with a high-risk tolerance.

Penny stocks exhibit higher volatility levels, offering greater potential for rewards but also carrying higher inherent risks. Investors should be mindful that investing in penny stocks, especially on margin, can result in complete loss or more than the initial investment.

To manage the risks associated with penny stocks, investors are advised to set stop-loss orders before trading to determine an exit price if the market moves unfavorably. It’s essential to temper expectations and recognize that penny stocks are volatile, high-risk investments with limited trading volumes.

Advantages and Disadvantages of Penny Stocks

Due to their low trading volumes, penny stocks tend to be more volatile than established equities, offering both significant opportunities for gains and risks that investors need to carefully evaluate.

Funding for Small Companies

Penny stocks offer small businesses a platform to access funding from the public, serving as a stepping stone for these firms to enter larger marketplaces.

High Potential for Growth

Given their low prices, penny stocks present potential for significant upside. Noteworthy companies like Amazon (AMZN) began as penny stocks before growing into prominent blue-chip firms.

Blue-chip companies are well-established, financially sound corporations known for their resilience and profitability even during challenging economic conditions, contributing to their stable growth and reliability.

However, investing in penny stocks entails risks, as these securities are generally riskier than those of established companies.

Why Do Penny Stocks Fail?

Lack of Information Available to the Public

Access to credible information is crucial in making informed investment decisions. Some penny stocks lack public information on corporate performance, and available data may not be from reliable sources.

OTCBB-traded stocks have an “OB” suffix to their symbol and are mandated to file financial statements with the SEC. Conversely, pink sheet-listed companies are not obligated to register with the SEC, exposing them to lower scrutiny.

No Minimum Standards

Stocks on the OTCBB and pink sheets lack minimum requirements to remain listed, potentially posing higher risks to investors compared to those of companies adhering to stringent standards on major exchanges.

Lack of History

Many penny stock companies are newly formed or nearing bankruptcy, often with limited or no track record. This lack of historical data makes it challenging to assess a stock’s potential value.

Liquidity and Fraud

Limited liquidity in infrequently traded stocks can hinder investors from selling shares. Moreover, low liquidity levels create opportunities for price manipulation, such as pump and dump schemes, leading to substantial losses for investors.

Low liquidity also enables stock price manipulations, like pump and dump schemes, where scammers artificially inflate stock prices to lure investors before selling off their shares, causing significant market losses once the scheme is revealed.

Pros

• Offer a place for small companies to gain access public funding.

• May provide a method for small companies to gain access to larger market listings.

• Allows for significant upside due to low stock prices.

Cons

• Lack of market liquidity with few buyers, especially post-price increase.

• Limited information available on company financial records.

• High likelihood of fraud and company bankruptcy.

Tips for Investing in Penny Stocks

To mitigate the volatility of penny stocks, investors should conduct thorough due diligence, evaluating company statements for financial health and stability. It’s crucial to engage reputable stockbrokers who can provide well-researched guidance and avoid investing more than what can be affordably risked.

Furthermore, investors are advised to be wary of scams commonly associated with penny stocks, often promoted through unsolicited emails or phone calls. By maintaining realistic expectations and avoiding over-investment, investors can navigate the inherent risks of penny stocks.

Can You Make Money on Penny Stocks?

While potential profits exist in trading penny stocks, investors must exercise caution and avoid fallacies commonly associated with speculative investments. While gains are possible, the equally high potential for significant losses should not be overlooked.

Investors should be wary of misconceptions like the low-price fallacy and recognize that market capitalization and liquidity play significant roles in stock valuation, preventing easy selling of large quantities that may impact stock prices.

Signs of Scams

Identifying fraudulent penny stocks can be challenging, but certain indicators can raise red flags. Investors should look out for signs like SEC trading suspensions, large assets with minimal revenues, unusual disclosure items, auditing irregularities, and significant insider ownership.

Real-World Example of Penny Stock Scams

A case involving Zirk de Maison highlights penny stock scams, where fraudulent shell companies were used to deceive investors with false promises of business activities. Despite the high-pressure tactics employed, perpetrators were eventually convicted of securities fraud and sentenced to federal prison.

How Is a Penny Stock Created?

Startups and small companies leverage stock issuance to raise capital quickly for business expansion. The process, known as an initial public offering (IPO), involves registering with the SEC or securing exemptions to list on platforms like the OTCBB.

After approval, companies may opt for listing on major exchanges or trade over-the-counter. Underwriting by attorneys or investment banks is essential, guiding the company through SEC regulations and disclosure requirements for public offerings.

Underwriting Penny Stock

Prior to trading in the secondary market, registered offerings require thorough underwriting, compliance with SEC regulations, and public dissemination of financial statements and sales materials.

Continuous provision of updated financial statements and adherence to disclosure requirements ensures investor information transparency and stock availability for trading on OTC or major exchanges.

Trading Penny Stocks

Following the IPO and initial investor orders, secondary market trading commences, enabling further capital raising through additional offerings. Continued financial statement disclosures and public updates are mandatory to maintain market engagement and stock liquidity.

Regulations for Penny Stocks

Considered highly speculative, penny stocks are subject to SEC and FINRA oversight, ensuring compliance with rules to safeguard investors. Broker-dealers must adhere to regulatory requirements, verifying transaction suitability, providing disclosures on risks, confirming market prices, and disclosing transaction-related fees.

• Approval of investor transactions and suitability verification under Exchange Act rules.
• Provision of a standardized disclosure document outlining risks, customer rights, and fraud remedies.
• Disclosure and confirmation of current prices before executing transactions.
• Transmission of account statements detailing penny stock holdings and market liquidity assessments.

After-Hours Trading

Trading after hours presents an opportunity for penny stocks to experience volatile fluctuations beyond regular market hours. However, despite potential high returns, post-hours trading faces challenges like limited liquidity and inferior reporting, making buying or selling stocks more challenging during extended trading sessions.

When Is It Not a Penny Stock?

Transitioning from penny to regular stock status can occur through events like SEC-registered security issuance or formal registration of existing securities, mandating periodic reports on business activities, financial health, and management details unless exempted.

Companies meeting specific criteria like shareholder count and asset thresholds must file mandatory reports with the SEC, ensuring public information transparency and compliance with established reporting guidelines.

Example of a Penny Stock

While most penny stocks do not trade on major exchanges, some large companies with market capitalization below $5 per share are listed on exchanges like Nasdaq. Catalyst Pharmaceuticals Inc. (CPRX) on Nasdaq serves as an illustrative penny stock example, reflecting price fluctuations and the inherent risks and rewards associated with such investments.

Where Do You Buy Penny Stocks?

Penny stocks are traded on the OTC Bulletin Board (OTCBB) or OTC Markets Group and are accessible through brokerage accounts like Fidelity or Charles Schwab.

How Do You Buy Penny Stocks on Fidelity?

To buy penny stocks on Fidelity, investors can search for stocks trading below $5 per share and acknowledge the risks associated with penny stock trading by submitting a form.

How Do You Find Penny Stocks on Robinhood?

Discovering penny stocks on Robinhood involves using the search function and filtering for companies trading under $5 per share. Given Robinhood’s commission-free structure, trading penny stocks on this platform can potentially yield higher profitability compared to traditional brokers.

The Bottom Line

Penny stocks, characterized by low prices and trading volumes, offer both significant profit opportunities and risks due to their inherent market volatility. Understanding the unique challenges and rewards of investing in penny stocks is essential for making informed and prudent investment decisions.