Penny stocks are shares offered by smaller companies for under $5 per share. They’re renowned for their low liquidity, high volatility – and the potential for huge rewards. While these traits make them exciting, penny stocks remain some of the riskiest stocks on the market.
The U.S. SEC defines penny stocks as “microcap stocks,” or shares issued by small companies that trade for under $5. (In the past, the upper limit was $1, thus the name.) Penny stocks are renowned for lax transparency and filing requirements, leading to low liquidity, high volatility and extra risk.
Public companies can issue their first penny stocks through an initial public offering (IPO). Prior to trading, penny stocks must register with the SEC or explain why they’re not required to. After receiving SEC approval, the issuing firm can list their shares.
Instead, most penny stocks trade electronically over-the-counter (OTC) on boards like the OTC Bulletin Board (OTCBB) or OTC Markets Group.
Unlike big exchanges, OTC boards have fewer listing requirements, including limited financial standards and regulatory disclosure rules. The Pink Open Market – the lowest tier of OTC Markets Group – sets no financial standards or disclosure requirements.
Most penny stocks are issued by small-cap companies worth around $300 million or less. Common examples include:
But some investors classify bigger stocks that have fallen from grace as penny stocks, too. Take Credit Suisse or Bed Bath & Beyond, both of which began trading below $5 per share consistently in September 2022.
Penny stocks are renowned for being speculative and even shady securities. But the market isn’t entirely unregulated: the SEC and FINRA require broker-dealers to follow several rules to trade these shares. Examples include:
Penny stocks serve several purposes for business. To start, they’re a relatively easy way to access much-needed funding without issuing debts. Some firms use penny stocks as a stepping-stone on the way to larger exchanges.
As an investor, penny stocks provide an asset ripe for speculation and the potential for enormous upside.
For instance, GameStop soared from $2.80 per share in April 2020 to a pre-market price of over $500 in January 2021. Though it’s seen some hefty swings (and a stock split) since, it sat around $20 as of April 2023.
But many companies don’t wait even that long. Between low liquidity and high volatility, penny stocks can gain 20%, 50%, even 200% in minutes to hours.
The combination of low cost and high upside potential often draws day and swing traders seeking short-term growth spurts. Investors with limited capital may also pick particularly promising penny stocks as long-term holdings – though that strategy carries its own risks.
Though their low prices and high reward potential seem appealing, penny stocks are some of the riskiest investments on the market.
Both the SEC and OTC boards set low (or no) minimum standard regulatory, financial and filing requirements for penny stocks. Investors may be buying stocks that are brand-new, highly unprofitable or even approaching bankruptcy. Some stocks may even have been delisted from larger exchanges for failure to follow stricter rules.
On the one hand, fewer requirements means that smaller firms can more easily raise capital. But it also increases risk by exposing investors to shady companies and scams.
Aside from lax regulations, stocks that trade OTC don’t always have to disclose their performance and decisions. They may also be excluded from the same rigorous accounting standards as stocks trading on major exchanges.
There’s some wiggle room here – for instance, stocks trading on the OTCBB must file financial statements with the SEC. But stocks listed on the Pink Sheets aren’t held to this same standard, allowing them to hide from public scrutiny and stricter regulation.
As a result, investors may have to make trading decisions based on unreliable, incomplete or even no information.
Penny stocks frequently suffer from relatively low buyer interest and sudden price swings. Combined with the smaller size of the OTC market, that means that most penny stocks are fairly illiquid. As a result, you may be unable to sell in a hurry when you need to lock in gains or avoid losses.
Due to the aforementioned dearth of liquidity and buyer interest, investors may also face wider bid-ask spreads. (Larger differences between the buyer and seller’s desired prices.) These may result from limited interest in a given stock, meaning it takes longer to match prospective buyers and sellers. Not to mention the longer it takes to sell, the bigger the chance that prices may move.
Low liquidity and limited trading volume have another consequence: even small transactions – think a few hundred shares – can spark major price swings. And in the penny market, that doesn’t have to mean much. When you’re trading under $5 apiece, a price swing of just 50 cents can be huge.
This high volatility means it’s possible to lose massive investments, particularly if you’re heavily concentrated in penny stocks. (Even more so if you buy on margin.) Though you can mitigate some of these risks with stop-loss orders, liquidity issues may prevent you from getting out before suffering substantial losses.
Overall, an abundance of speculation and lack of strict regulations make penny stocks perfect for shady firms and scammers.
Pump-and-dump schemes are particularly prevalent. Essentially, this is a type of market manipulation where paid promoters falsely hype a stock until investors pile in and the price spikes. Then, the promoters cash out at the peak and disappear with all the capital gains – leaving investors holding worthless shares.
It’s crucial to remember that penny stocks offer high potential – and very real risks.
Wannabe penny stock investors should research each investment to determine its financial profile and transparency and sniff out any red flags. You might even enlist a reputable investment firm or stockbroker to conduct some high-quality research.
And importantly, if you don’t understand what the business does, it’s likely unwise to invest.
But if you’ve done your research and feel comfortable taking the next step, keep in mind these tips:
You can find most penny stocks trading OTC, though a few trade on the NYSE or Nasdaq. To actually purchase your shares, you’ll have to sign up with a brokerage or investment firm that permits these kinds of trades. In the modern age, online brokerage accounts may be your best bet. However, they may lack trained stockbrokers to help shape and guide your investment strategy.
The right penny stocks to buy inevitably change with market trends and new innovations. And, truthfully, few penny stocks are ever really “right” for most retail investors.
But as a guideline, you should look for penny stocks issued by companies that:
With all the risks and fraud potential, asking whether penny stocks are worth your time is a very good question. And for many investors, the answer is simple: no.
Penny stocks may be cheap, but they’re also characterized by incredibly low volume and high volatility. And since many don’t have to provide financial or governance disclosures, it’s impossible to determine how they’re really doing.
Not to mention, the majority of penny stocks rarely outperform – true winners are few and far between.
You can add penny stocks to your investment strategy by opening an account that permits OTC trades. But we here at Q.ai typically discourage investing in such risky strategies alone.
Instead, we prefer data-driven investments backed by the power and intelligence of AI. With Q.ai’s unique Investment Kits, you can invest in a range of assets that fits your risk tolerance and long-term goals.
No, it’s not quite penny stock investing. We think it’s better.
Learn everything about Q.ai Investment Kits and how they help build wealth
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