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What are Penny Stocks? | Simply Explained | Beginner’s Guide

What are Penny Stocks
Anastasia
Menshikova
Updated: 30 Dec, 2021
9 mins read

This guide will take a detailed look at penny stocks, the cheap shares of small companies commonly sold outside of securities exchanges. You will learn about different penny stock firms, their appeal to investors, their risks, and the pros and cons of this type of stock trading.

Penny Stocks definition

Penny stocks are stocks that are sold below $5 per share. Historically, this term referred to stocks less than $1 in price, but this meaning has changed over time. 

Traditionally, Penny Stocks are issued by small or young companies and by ones that have or are experiencing financial difficulties (e.g., bankruptcy). Commonly, investments in Penny Stocks are connected with high risks. For this reason, you can hardly find Penny Stocks on securities exchanges like the NASDAQ or the New York Stock Exchange (NYSE), as they have strict requirements for companies to be included in their listings, and such enterprises rarely meet these criteria.

Till November 2021, penny stocks were mostly traded through instruments for off-exchange trading like Over-the-Counter-Bulletin-Board (OTCBB) or OTC Markets Group‘s Pink Sheets (The Open Market). However, on November 8, 2021, FINRA announced the closure of the OTC Bulletin Board leaving the OTC Markets Group as a core player in the penny stocks market.

The Pink Sheets system provides investors with information only about price and liquidity. Still, it is not registered with the Securities and Exchange Commission and, as a result, does not guarantee fulfillment of listing requirements. Therefore, investors should be aware that trading on Pink Sheets is connected with high risks. 

Note: To learn more about Over-the-Counter trading specifics be sure to read our comprehensive ‘What is OTC?’ guide.

Penny Stocks also have some more peculiarities like:

  • In comparison with conventional shares like Blue-Chip stocks (stocks that are issued by large, well-established companies that have a proven track record of financial success), the liquidity of Penny stocks is much lower. 
  • Companies that issue Penny Stocks go through a simplified procedure of state registration or are released from this procedure.
  • Normally, it is hard to find any clear information about Penny Stocks companies as there is there is not as much data on them available in comparison with companies from listings. 

Watch the video: Penny Stocks, Micro Caps, and OTC Stocks Explained

Why do investors choose to invest in Penny Stocks?

As previously mentioned, penny stocks can be a high-risk investment with some peculiarities, but still, investors choose these shares for trading. Mainly the reasons for this are as follows:

1. High Volatility

Given the extreme volatility of penny stocks, it is possible to make a larger profit in a shorter period of time than with blue-chip stocks. For example, if you buy a share for $1 today, it may be worth $1.50 tomorrow, resulting in a 50% profit. 

2. Find a hidden gem

Penny Stocks that startup companies issue can shoot to the moon and bring substantial gains. There are many successful examples in history (some of the most famous companies that started as Penny Stocks are Monster Beverage, Apple, and Ford Motor). Still, investors are advised to be careful when choosing a Penny Stock company as there is a lot of fraudulence and manipulations in this stock market sector. 

3. Lucrative merge

Another way to profit from Penny Stocks is to invest in companies with low liquidity with an eye towards possible lucrative mergers. It means that if the company behind the Penny Stock merges with a bigger company and thus becomes more profitable. 

Before you put your money into the penny stock

The importance of thorough analysis and an in-depth examination of the company cannot be overstated when selecting the most suitable firm for penny stock investing. Hence, before you put your money into penny stocks, be sure to:

  • Do your own research (DYOR) on the company’s financial status, team and products, as well as past performance in the market;

  • Examine the company’s stock price performance during the course of its lifetime;

  • Follow the stock price’s trend as ‘the trend is your friend‘;

  • Diversify your portfolio by purchasing several distinct penny stocks instead of just one. This way you don’t put all your eggs in one basket;

  • Most important – establish a trading strategy before you purchase stocks, You must determine what your exit price objective is for the position. As professional traders say: ‘Plan you trade and trade your plan‘.

Where to buy penny stocks?

Penny stocks are mostly traded through the OTC Markets Group‘s Pink Sheets. However, some of the low-priced penny stocks you can find on the stock trading platform Interactive Brokers (IBKR). However, before proceeding, be sure to read IBKR’s “Penny Stock Trading Risk Disclosure” [PDF].


Penny stocks examples

To understand penny stocks more precisely, here’re a few examples of some recognized companies that are considered as proper penny stocks:

TOMI Environmental Solutions, Inc. (TOMZ)

Denison Mines Corp. (DNN)

Playstudios, Inc. (MYPS)

Ambev S.A. (ABEV)

Pros and Cons of penny stocks investing

Pros

High income potential

Traditionally, penny stocks are issued by small and young companies that need to earn equity capital for future development or companies that recover after a difficult financial situation or bankruptcy. These companies have the opportunity to grow rapidly. Therefore, it is essential to analyze and estimate the possible potential of the company by analyzing the market, company, and situation in the world. 

Low price

Beginners to stock trading when investing often buy penny stocks due to their affordable price. In this case, they get more shares for a smaller amount of money and then get higher profit even with little changes in price to the upside. Also, if the stock collapses, the losses might not be so high compared to more expensive shares (of course, it depends on the amount invested).

Cons

Lack of information

Penny stock companies are considered to be small and young, and thus, there might not be so much information available. That may lead to problems with the estimation of possible risks and losses when deciding whether to invest. 

Low standards

To be listed in Pink Sheets or OTBB, the penny stock company does not have to provide all the information the NASDAQ or NYSE requests.  It does not always lead to fraud or speculation, but it means that the investor should be more attentive when reading the charts and information as it is often limited.

Low Liquidity

Penny stocks are often linked with small businesses and are traded infrequently, resulting in a lack of liquidity and an absence of genuine and consistent buyers on the market. As a result, investors may face difficulties with trading these shares due to a lack of buyers, and then they may be stuck with a number of stocks that cannot be sold what is referred to in trading as ‘left holding the bag.’

Moreover, because of low liquidity, investors may face difficulties in defining the proper price for stocks. That is why Penny Stocks are often considered speculative, and investors may lose a significant part or even all of their investments.

Fraudulence

Penny stocks are often the target of financial fraud and scams. Fraudsters establish companies, then issue large amounts of stocks at a low price and later announce bankruptcy or even flee with the money.

Furthermore, fraudsters create artificial interest in the shares of different companies by buying large amounts of penny stocks at low prices. They may also publish fake news about the company’s activity. These actions raise the interest of other investors who start to buy these shares at a higher price, and then the price falls again, and investors lose their money.

According to the Securities Exchange Act, this type of fraud is called Pump and Dump (P&D) and is illegal and leads to fines and imprisonment.

Conclusion

Trading penny stocks on the stock market is a very controversial issue. Usually, penny stocks are traded by beginners with low budgets or professional traders who have trained eyes and can differentiate between the companies and evaluate possible outcomes. 

Penny stocks usually have low prices and high volatility, but on the other hand, they are an instrument for frauds and scams. That is why all the operations with these shares should be analyzed and carefully checked. However, penny stocks may provide a solid opportunity to invest in a startup company that has a chance to develop quickly.

 FAQs about Penny Stocks

Why are Penny Stocks popular?

There might be three reasons for the popularity of Penny Stocks trading:

  1. There are people who do not have large amounts of money but want to learn about investments.
  2. People are looking for startup ideas that can be successful (let’s say ‘another Apple’).
  3. People are using Penny Stocks for frauds and scams.

Where can I buy Penny Stocks?

Penny stocks are mostly traded through the OTC Markets Group‘s Pink Sheets. However, some of the low-priced penny stocks you can find on the stock trading platform Interactive Brokers (IBKR). However, before proceeding, be sure to read IBKR’s “Penny Stock Trading Risk Disclosure” [PDF].

Why do companies issue Penny Stocks?

Traditionally, Penny Stocks are issued by small and young companies which need investments for further development. But also, old and trustworthy companies may sell Penny stocks due to a difficult financial situation or recovering after bankruptcy. 

Should I buy Penny Stocks for short-term or long-term?

It depends on your investing plan. It is better to make the move once you know when you plan to close the position. Plan your trade – trade your plan. It solely depends on your personal goals and your research skills.

Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.

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Anastasia Menshikova
Author

Anastasia Menshikova is an experienced content creator specializing in business, economics, IT and accounting. Her previous teaching expertise allows her to present complex ideas in an easy and accessible manner.

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