What are Penny Stocks?

Investing in a penny stock is like pulling your goalie during a hockey game…

When you pull your goalie off the ice in a hockey game, you get to have one extra person try to score a goal. However, you don’t have anyone defending the net, so it’s easy for the other team to score. You take a big risk for a chance at a big reward. Penny stocks are similar. They’re small, untested companies, so investing is a big risk.

Penny stocks are shares issued by small companies, typically with a price below $5 per share. They get their name from the fact that you can often buy penny stocks for less than a dollar (meaning you can pay in pennies). This was especially true decades ago, before inflation drove the prices of shares in these kinds of businesses above $1.

The majority of penny stocks don’t trade on major stock exchanges, though there are a small number that do. Instead, penny stocks typically change hands in over-the-counter transactions. That means traders who buy and sell penny stocks work directly with stockbrokers and dealers to complete transactions rather than using an exchange such as the New York Stock Exchange or NASDAQ.

Many penny stocks experience low levels of liquidity, meaning that people buy and sell shares infrequently. While millions or tens of millions of shares in a major company could change hands in a single trading day, a penny stock may see fewer than a thousand shares, or even no shares, change hands.

The lack of liquidity in penny stocks leads to a few things that investors need to keep in mind. One is that illiquid securities are difficult to price. When many people want to buy or sell shares in a company, the price will generally find an equilibrium between the level of supply and demand. But when few people transact, as is often the case with a penny stock, it’s much harder to discover the fair price for the security.

Low liquidity also means that investors might not have the opportunity to sell their penny stocks after buying them. If nobody wants to purchase the shares, they might be stuck in the investor’s account.

The risk of investing in penny stocks is high. It’s difficult to determine their fair value, investors can struggle to sell them due to low trading volumes, and many penny stocks provide far less information to the public than major companies do.

Still, one appeal of investing in penny stocks is that a person doesn't need much to get started. Penny stock shares are cheap, so they can be purchased as long as the account has sufficient funds.

Like other investments, the more money a person has, the more they can purchase. If a person has $5 and wants to buy shares in a penny stock trading at $1, then they can buy five shares. If the person has $500, they could buy 500 shares. The more shares a person owns, the more the value of their holdings may rise or fall.

If your brokerage charges a commission for penny stock transactions, consider how much the commissions will cost compared to the value of your investment. For example, if you put $5 into a penny stock and pay $2.50 in commission for each purchase or sale, you would need your investment to appreciate by 50% just to break even.

It’s very difficult to make money from penny stocks, and the majority of people who try to fail. You’re far more likely to lose money than you are to succeed at trading penny stocks.

Some investors have turned a profit through penny stock trading, but they are by far the exception rather than the rule. Investing in penny stocks is incredibly risky and many investors have lost large sums of money by investing in penny stocks.

One major risk of investing in penny stocks is that the SEC applies less stringent reporting rules to them than it does to larger firms. Companies with fewer than 2,000 investors and less than $10M in assets don’t have to submit financial reports in the same way most public companies do. That makes it difficult for investors to know the health of the business.

Another risk of penny stocks is that it’s difficult to know a fair price for each share. When a company’s shares trade frequently, the price quickly reaches equilibrium based on the level of supply and demand. Penny stock shares can trade just a few times an hour, day, or even a week. When few people want to trade, it can be hard to determine a fair price. The lack of reporting requirements also makes fundamental analysis of the underlying business difficult.

Many penny stocks come from brand new companies. That means that the firms have almost no track record for investors to base their decisions on. Investing in an untested company is risky because it’s difficult to predict whether the company will perform well or not. Businesses with longer histories tend to have more experienced management and staff, which can contribute some amount of stability.

Another risk is that it's easier for malicious actors to manipulate the prices of penny stocks. One investor buying many shares in a penny stock may cause its price to increase significantly. One investor selling many shares may cause a penny stock's price to crater. While the SEC remains on the lookout for so-called pump-and-dump schemes and other illegal manipulation, penny stocks are far more susceptible than larger companies.

The reality is that investing in penny stocks is generally considered a bad idea. It’s difficult to find reliable information about them, and they are far more dangerous than other types of securities.

One reason that it’s so hard to find information about penny stocks is that while the companies do need to submit certain reports to the Securities Exchange Commission, they don’t have to submit the same reports as larger firms.

Many brokerages make it intentionally difficult to start investing by adding additional requirements before a person can begin placing penny stock trades, such as calling and placing trades over the phone rather than through a web portal.

All investing carries risk; always keep investment objectives in mind.

People can buy penny stocks using almost any brokerage account.

Some brokerages may apply additional restrictions or requirements before they let their customers trade penny stocks. They intend for these requirements to protect inexperienced investors from the higher levels of risk involved with penny shares.

For example, you may need to call and speak to a representative over the phone to authorize an investment in penny stocks, rather than placing an order from your account’s web portal.

Penny stocks are extremely risky, and historically only a very small percentage have ever succeeded. Loss of large percent of your investment is likely.