What Are Penny Stocks?

Penny stocks, also known as micro-cap stocks, are stocks offered by a small company for less than $5 per share.

🤔 Understanding penny stocks

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).

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.

But 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.

What are 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

What this means for you

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.