What Is a Penny Stock?

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 New York Stock Exchange (NYSE), most penny stocks trade via over the counter (OTC) transactions.

Transactions take place through the electronic OTC Bulletin Board (OTCBB) or through the privately-owned Pink Sheets. There is no trading floor for OTC transactions, and the quotations are also all done electronically.

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Penny Stocks

Penny Stocks Explained

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 as they maintain fair and orderly functioning of the securities markets.

Penny stocks are usually associated with small companies and trade infrequently meaning they have a lack of liquidity or ready buyers in the marketplace. As a result, investors may find it difficult to sell stock since there may not be any buyers at that time. 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.

Key Takeaways

  • 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 via 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.

Price Fluctuations of Penny Stocks

Penny stocks offered on the marketplace are often 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. Buying on margin means the investor borrowed funds from a bank or broker to purchase the shares.

Considering the heightened risk levels associated with investing in penny stocks, investors should take particular precautions. 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 opposite of the intended direction. Stop-Loss orders are instructions, placed with the broker, that set a price limit that once reached, will trigger an automatic sell of the securities.

Although penny stocks can have explosive moves, it is important to have realistic expectations whereby investors understand that penny stocks are high-risk investments with low trading volumes.

What Makes Penny Stocks Risky

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. Also, since they sell as such low prices, there is room for significant upside. However, some factors exacerbate the risk associated with investing or trading penny stocks. The securities are usually riskier than more well-established companies known as blue-chip stocks.

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.

Lack of Information Available to the Public

It's important with any successful investment strategy to have enough information to make an informed decision. For penny stocks, information is much more difficult to find as compared to well-established companies. Also, information available about penny stocks 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 regulated 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 on the exchange. 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 act as a safety cushion for some investors and as a benchmark for some companies.

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 or dump their shares. Once the market realizes there was no fundamental reason for the stock to rise, investors rush to sell and take on losses.

Pros

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

  • In some few 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.

Cons

  • 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 soundness or track record.

  • Penny stocks have a high probability of fraud and bankruptcy of the underlying company.

Signs of Fraud

Though there is no fool-proof safeguard with penny stocks, the SEC recommends that investors look out for the following warning signs: SEC trading suspensions, spam, 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 Fraud

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 through "boiler rooms," offices where brokers use high-pressure tactics to push people into buying stocks by promising large profits, embezzling $39 million. 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. Though 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, or OTC.

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 to the public for 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 via 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 the 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 maintain the ability for quoting on the Over-the-Counter Bulletin Board.

The SEC's Rules for Penny Stocks 

Penny stocks are considered highly speculative investments. To protect the investor’s interest, the SEC and the Financial Industry Regulatory Authority (FINRA) have specific rules to regulate the sale of penny stocks. All broker-dealers need to comply with the requirements of Section 15(h) of the Securities Exchange Act of 1934 and the accompanying rules to be eligible to handle any transactions in penny stocks.

  • Following the rules of SEC §240.15g-9, the broker-dealer must approve the investor's transaction and make sure the investment is suitable for their purchase. 
  • They must give a standardized disclosure document to the customer as outlined in §240.15g-2. This document contains an explanation of the risk associated with buying penny stocks, customer rights, and remedies in cases of fraud.
  • Broker-dealers must follow §240.15g-3 and disclose and confirm the currently quoted prices before completing the transaction.
  • SEC rule §240.15g-4 states the broker must tell the investor about the funds they earn by facilitating the transaction.
  • Brokers must send monthly account statement that includes details about the number and identity of each penny stock in the customer's account as described by rule §240.15g-6. These broker-dealer 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.

After-Hours Trading

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 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 or more than 500 investors that can’t be categorized as accredited investors, and who possess more than US$10 million in assets. Usually, companies with no more $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.

If a business lists its securities on any national security exchange, such as the NYSE or the Nasdaq, it must file as well. Lastly, SEC registration is mandatory if a company’s securities are quoted on the OTCBB or under the OTCQB marketplace of the OTC Link.

Example of a Penny Stock

Most penny stocks don’t trade on the 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.

An example of a penny stock listed on the Nasdaq is Curis Inc. (CRIS), a small biotechnology company.

  • On March 13, 2019, CRIS closed at $1.29 for that day.
  • By the end of the next day, March 14, 2019, CRIS posted a $1.47 closing price.
  • In other words, the stock price for CRIS gained approximately 14% in one day.
  • However, a week earlier, CRIS traded at $1.15 at the close of the day March 5, 2019.
  • Three days later, the stock closed at $1.06 for March 8, 2019. The loss in value was 8.5% for the three days.

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.