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. Though some penny stocks trade on large exchanges such as the New York Stock Exchange (NYSE), most trade via over-the-counter (OTC) transactions through the electronic OTC Bulletin Board (OTCBB) or through the privately-owned OTC Markets Group.
There is no trading floor for OTC transactions. Quotations are also all done electronically.
- A penny stock refers to a small company's stock that typically trades for less than $5 per share.
- Although some penny stocks trade on large exchanges such as the NYSE, most penny stocks trade over the counter through the OTC Bulletin Board (OTCBB).
- While there can be sizable gains in trading penny stocks, there are also equal risks of losing a significant amount of an investment in a short period.
Understanding Penny Stocks
In the past, penny stocks were considered any stocks that traded for less than one dollar per share. The U.S. Securities and Exchange Commission (SEC) has modified the definition to include all shares trading below five dollars. The SEC is an independent federal government agency responsible for protecting investors by maintaining the proper and orderly functioning of the securities markets.
Penny stocks are usually associated with small companies with a lack of liquidity, meaning that there are few ready buyers in the marketplace. As a result, investors may find it difficult to sell stock since there may not be enough buyers. Because of the low liquidity, investors might have difficulty finding a price that accurately reflects the market.
Due to their lack of liquidity, wide bid-ask spreads or price quotes, and small company sizes, penny stocks are generally considered highly speculative. In other words, investors could lose a sizable amount or all of their investment.
Penny Stock Volatility
Penny stocks often represent growing companies with limited cash and resources. Since these are primarily small companies, penny stocks are most suitable for investors who have a high tolerance for risk.
Typically, penny stocks have a higher level of volatility, resulting in a higher potential for reward and, thus, a higher level of inherent risk. Investors may lose their entire investment on a penny stock, or more than their investment if they buy on margin, which means the investor borrowed funds from a bank or broker to purchase the shares.
Investors should consider the heightened risks associated with penny stocks. For example, an investor should have a stop-loss order predetermined before entering a trade and know what price level to exit if the market moves against them. Stop-loss orders set a price limit that, once reached, will trigger an automatic sale of the securities.
Although penny stocks can have explosive gains, it is essential to have realistic expectations and understand that penny stocks are high-risk investments with low trading volumes.
Advantages and Disadvantages of Penny Stocks
Due to their low volume, penny stocks tend to be more volatile than established equities. This means high opportunities for both gains and losses, and investors should be careful to understand both the risks and benefits.
Funding for Small Companies
Penny stocks do provide some small businesses with a way to access funding from the public. These companies may use this platform as a starting block to move into a larger marketplace.
High Potential for Growth
Also, since they sell at such low prices, there is room for significant upside. Some companies, such as Amazon (AMZN) originated as penny stocks but later grew into sizable blue-chip companies.
A blue chip is a nationally recognized, well-established, and financially sound company. Blue chips generally sell high-quality, widely accepted products and services. Blue-chip companies typically have a history of weathering downturns and operate profitably in the face of adverse economic conditions, which helps to contribute to their long record of stable and reliable growth.
However, some factors exacerbate the risk associated with investing in or trading penny stocks. These securities are usually riskier than more established companies.
Why Do Penny Stocks Fail?
Lack of Information Available to the Public
When considering options for potential investments, it's important to have enough information to make an informed decision. For some penny stocks, information on corporate performance can be very difficult to find. When this is the case, the information that is available about them may not come from credible sources.
Stocks traded on the OTCBB carry the "OB" suffix to their symbol. These companies file financial statements with the SEC. However, companies listed on the pink sheets are not required to file with the SEC. As such these businesses do not receive the same public scrutiny or regulation as the stocks represented on the NYSE, the Nasdaq, and other markets.
No Minimum Standards
Stocks on the OTCBB and pink sheets do not have to fulfill minimum standard requirements to remain available for sale through OTC exchanges. Once a company can no longer maintain its listing position on one of the major exchanges, the company can move to one of the smaller OTC listing exchanges. Minimum standards can act as a safety cushion for some investors. When a company is not subject to higher standards, investing in that company becomes much riskier.
Lack of History
Many of the companies considered to be penny stocks could be newly formed, and some could be approaching bankruptcy. These companies will generally have poor track records or no track record at all. As you can imagine, this lack of historical information makes it difficult to determine a stock's potential.
Liquidity and Fraud
Stocks that trade infrequently do not have much liquidity. As a result, it is possible that investors won't be able to sell the stock once it is acquired. The investors might need to lower their price until it is considered attractive to another buyer.
Low liquidity levels also provide opportunities for some traders to manipulate stock prices. The pump and dump scheme is a popular trading scam to lure investors into buying a stock. Large amounts of a penny stock are purchased followed by a period when the stock is hyped up or pumped up.
Once other investors rush to buy the stock, the scammers sell their shares. Once the market realizes there was no fundamental reason for the stock to rise, investors rush to sell and can take on heavy losses.
Offer a place for small companies to gain access public funding.
In some cases, penny stocks may provide a method to gain access to larger marketplace listing.
With a lower price, penny stocks allow for significant upside in share appreciation.
Penny stocks lack a liquid market with few buyers, perhaps even after their price has increased.
There is limited information available on the company's financial record.
Penny stocks have a high probability of fraud and bankruptcy of the underlying company.
Tips for Investing in Penny Stocks
While penny stocks are volatile, there are some cautions that an investor can take to reduce their downside risk. One is to conduct proper due diligence: Since penny stocks tend to trade in venues with lower entry requirements, investors should take extra care to read the company's statements and ensure that the company is financially sound.
It is also important to rely on reputable stockbrokers. While there are scams to watch out for, most of them are promoted by dubious emails and cold calls. A reputable broker should be able to provide high-quality written research to back up any investment claims.
Finally, as with any speculative investment, never put in more money than you can afford to lose. While you may make a profit by day trading, the returns are much more steady with established, large-cap equities.
Can You Make Money on Penny Stocks?
Despite the risks, penny stocks can be profitable for a cautious or thorough investor. The key is to avoid certain fallacies that are common among speculative investments, such as the belief that they have the opportunity to make large gains. While this is true, they are equally likely to score large losses.
Another important fallacy to avoid is the low-price fallacy, which holds that low-priced securities are inherently "cheaper" than higher-priced ones. However, this does not account for factors like market capitalization or liquidity. Even if a certain stock doubles in price, it may be impossible to sell a large number of stocks without causing price slippage.
Signs of Scams
Though there is no fool-proof strategy for knowing which penny stocks are fraudulent, the SEC recommends that investors heed the following warning signs in a company's record: SEC trading suspensions, large assets but small revenues, financial statements containing unusual items in the footnotes, odd auditing issues, and large insider ownership.
Real-World Example of Penny Stock Scams
California resident Zirk de Maison created nearly half of a dozen shell companies and offered them as penny stocks to investors between 2008 and 2013, according to the Federal Bureau of Investigation (FBI).
De Maison told investors that the companies engaged in a variety of businesses, such as gold mining and diamond trading when, in fact, they did nothing. He sold the stocks in "boiler rooms," offices where brokers use high-pressure tactics to push people into buying stocks by promising large profits. In 2015, de Maison and seven other perpetrators were found guilty of securities fraud and sentenced to federal prison.
How Is a Penny Stock Created?
Small companies and startups typically issue stock as a means of raising capital to grow the business. Although the process is lengthy, issuing stock is often one of the quickest and most effective ways for a startup company to obtain capital.
A penny stock, like any other publicly traded stock, is created through a process called an initial public offering or IPO. To be listed on the OTCBB the company must first file a registration statement with the SEC or file stating the offering qualifies for an exemption from registration. It must also check state securities laws in the locations it plans to sell the stock. Once approved, the company may begin the process of soliciting orders from investors.
Finally, the company can apply to have the stock listed on a larger exchange, or it can trade on the over-the-counter market.
Underwriting Penny Stock
As with other new offerings, the first step is hiring an underwriter, usually an attorney or investment bank specializing in securities offerings. The company's offering either needs to be registered with the SEC, according to Regulation A of the Securities Act of 1933, or file under Regulation D if exempt. If the company is required to register, Form 1-A, the registration statement, must be filed with the SEC along with the company's financial statements and proposed sales materials.
The financial statements need to remain available for the public to review, and timely reports must be filed with the SEC to maintain the public offering. Once approved by the SEC, orders for shares may be solicited from the public by accompanying sales materials and disclosures, such as a prospectus.
Trading Penny Stocks
After initial orders are collected and the stock is sold to investors, a registered offering can begin trading in the secondary market by listing on an exchange like the NYSE, Nasdaq, or trade over-the-counter. Many penny stocks wind up trading via OTC due to the strict requirements for listing on larger exchanges.
Sometimes companies make an additional secondary market offering after the IPO, which dilutes the existing shares but gives the company access to more investors and increased capital. Furthermore, it is mandatory that the companies continue to publicly provide updated financial statements to keep investors informed and continue to be quoted on the Over-the-Counter Bulletin Board.
Regulations for Penny Stocks
Penny stocks are considered highly speculative investments. To protect investors, the SEC and Financial Industry Regulatory Authority (FINRA) have rules to regulate the trading of penny stocks. All broker-dealers must comply with Section 15(h) of the Securities Exchange Act of 1934 and the accompanying rules to be eligible to handle penny stock transactions.
- Following Exchange Act rules of §240.15g-9, the broker-dealer must approve the investor's transaction and make sure the investment is suitable for their purchase.
- They must provide the customer with a standardized disclosure document as outlined in §240.15g-2. This document explains the risks associated with buying penny stocks, customer rights, and solutions in cases of fraud.
- Rule §240.15g-3 requires broker-dealers to disclose and confirm currently quoted prices before completing a penny stock transaction.
- Rule §240.15g-4 states the broker must tell the investor about the funds the broker earns from facilitating the transaction.
- Brokers must send monthly account statements that include details of the number and identity of each penny stock in the customer's account, as described by rule §240.15g-6. These statements must explain that the penny stock has limited market liquidity and provide an estimate of what they think the shares are worth in this limited market.
Penny stocks can be traded after hours, and since many significant market movements can happen after exchanges close, penny stocks are subject to volatile fluctuations after-hours. If penny stock investors execute buy or sell trades after-hours, they may be able to sell shares for very high prices or purchase shares for very low prices.
However, even the best penny stocks are subject to low liquidity and inferior reporting. Also, if a penny stock does spike after hours, an investor looking to sell the stock might have a hard time finding a buyer. Penny stocks infrequently trade, even more so after market hours, which can make it difficult to buy and sell after hours.
When Is It Not a Penny Stock?
Multiple events can trigger the transition of a penny stock to a regular stock. The company can issue new securities in an offering that is registered with the SEC, or it can register an existing class of securities with the regulatory body.
Both types of transactions automatically require the firm to adhere to periodic reporting, including disclosures to investors about its business activities, financial conditions, and company management unless there is an exemption. These filings also mandate 10-Q quarterly reports, the annual Form 10-K, and periodic Form 8-K reports, which detail unexpected and significant events.
In some instances, there are additional conditions that will require a company to file reports with the SEC. Reports must be filed if a company has either at least 2,000 investors, more than 500 investors that can’t be categorized as accredited investors, and possesses more than US$10 million in assets.
Usually, companies with no more than $10 million in assets and fewer than 2,000 recorded shareholders don’t have to adhere to reporting guidelines under the SEC. Interestingly enough, some companies opt for transparency by filing the same types of reports that other, perhaps more reputable, firms are required to do.
Example of a Penny Stock
Most penny stocks don’t trade on major market exchanges. However, there are some large companies, based on market capitalization, that trade below $5 per share on the main exchanges like the Nasdaq.
One example of a penny stock listed on the Nasdaq is Catalyst Pharmaceuticals Inc. (CPRX), a small biopharmaceutical company based in Coral Gables, Florida. As of Jan. 7, 2021, the stock price is $3.55 per share. In the last 12 months, the share price has fluctuated between $2 and $5. On Aug. 10, 2020, the stock closed at $4.26; however, the next day the price fell to $3.34 a drop of nearly 22%.
Although there can be sizable gains in trading penny stocks, there are also equal or larger risks of losing a significant amount of an investment in a short period.
Where Do You Buy Penny Stocks?
Penny stocks are traded on the OTC Bulletin Board (OTCBB) or the OTC Markets Group. They are also available to trade through a brokerage account, such as Fidelity or Charles Schwab.
How Do You Buy Penny Stocks on Fidelity?
You can buy penny stocks on Fidelity by searching for companies that trade for less than $5 per share. Note that those trading penny stocks must first submit a form acknowledging that they understand the risks of penny stock trading.
How Do You Find Penny Stocks on Robinhood?
You can find penny stocks on Robinhood using the search function, and setting a filter for only those companies trading for less than $5 per share. Note that since Robinhood does not charge commissions, penny stock trades can be potentially more profitable than a commission-based broker.
The Bottom Line
Penny stocks refer to shares in companies with a low price and low trading volume. Because these markets have low liquidity, there is also high volatility. This means more opportunities for large profits—or losses.