What are Penny Stocks?

December 9, 2021

What if we said you could invest in the stock market for $5 or less?

For new investors with limited funds (or seasoned investors who are looking for cost-effective ways to grow their available investment capital), penny stocks offer a way to dip your toes into the market without spending a lot at the outset. The question is whether a stock like that is worth the money.

Here’s what investors need to know about penny stocks and whether penny stocks might be the right choice for your portfolio.

What are Penny Stocks?

A penny stock is a stock sold by a small company that typically trades for less than $5 per share. Some penny stocks trade on the major stock exchanges, but most trade in over-the-counter transactions on the OTC Bulletin Board or the OTC Markets Group.

As the name implies, penny stocks used to trade for less money, though it was usually a dollar per share. The Securities and Exchange Commission modified the definition to include stocks trading for $5 or less.

Typically, penny stocks are associated with small companies and trade infrequently. As a result, they can be considered illiquid—a significant departure from your typical stock, which is one of the best examples of a highly liquid asset. They also tend to feature a wide bid-ask spread. And since penny stocks don’t trade on exchanges with trading floors (quotations all happen electronically) penny stocks are considered a speculative investment.

How is a Penny Stock Created?

If you’re paying attention, you’ll notice that penny stocks are typically limited to small companies. You won’t find penny stocks for a Fortune 500 company (which has no incentive to sell stocks for that low a price). But you can find penny stocks for small companies and startups, which often rely on penny stocks as a means to build capital.

Like any other publicly traded stock, a penny stock is created through an initial public offering (IPO). In order to have penny stocks listed for sale, the company must show its SEC registration (or paperwork showing exemption from registration) and check the local securities law boxes in any states where it intends to sell the stocks.

Once that’s approved, the company can begin the process of soliciting orders from investors. Thus, the penny stock comes into being.

Understanding Price Fluctuations

Price fluctuations and overall volatility are common features of penny stocks—and considering that regular stocks can be volatile, that’s saying something. Remember, penny stocks are typically issued by small companies and startups with limited capital and scant resources.

The benefit, of course, is getting in on the ground floor for cheap before the stock price shoots up. Or at least, that’s the promise that a company makes to each penny stock investor. And since the stocks are cheap, it’s relatively easy to invest in a lot of them.

Of course, penny stocks are issued by small companies that aren’t necessarily well-established yet. Penny stocks are volatile because the risk of the company going under are high. This means that the investor may well lose their entire investment just as easily as they might see explosive returns.

In other words, it’s a classic high-risk high-reward investment.

What Makes Penny Stocks Risky

There are several key features that make penny stocks risky, especially in comparison to regular stocks. It is a great way for a young company to build capital and shift to a large exchange, which means the potential returns can be high. But as with any investment, it’s worth knowing the risks—and penny stocks carry a few of them.

Lack of Public Information and History

As with any investment, you need to be able to make an informed decision. The challenge with penny stocks is that many of them don’t have much information available.

This often happens for perfectly legitimate reasons. Young companies haven’t been on the market very long and don’t have a lengthy business history to demonstrate their investment value. On the other hand, this lack of corporate information can be a sign of fraud.

The trick is to pay attention to the details of the stock. Penny stocks traded on the OTCBB carry the suffix “OB” on their symbol, which means the company had to file registration paperwork with the SEC. Companies listed on the pink sheets are not required to file with the SEC, which means they’re not subject to the same scrutiny. Stay off the pink sheets and look for the OB.

Lack of Minimum Standards

Regardless of whether a penny stock is listed on the OTCBB or the pink sheets, it doesn’t have to fulfill a minimum standard to stay listed. This is a sharp departure from regular stocks—on a larger exchange, if a company cannot meet minimum standards, it cannot trade on the exchange.

Basically, penny stocks don’t come with the same safety net you expect from a typical stock. That doesn’t necessarily mean the company is sketchy, but it does mean that you have to read between the lines and accept a higher level of risk at the outset.

Getting Started in Penny Stocks

To be clear, the riskiness of penny stocks doesn’t mean you should run the other way. With the right company and the right investment, penny stocks offer a great opportunity to get in on the ground floor and realize major returns.

If you’re considering investing in penny stocks, you have to do your research. Hunt down every piece of information you can find about a company, including its financials and the entity responsible for auditing the company, and then turn a critical eye to what you find. If the statements are quality and demonstrate a strong company with solid practices, it may be worth the investment.

Help Your Portfolio Thrive with Alternative Investments

For investors looking to make the most of limited resources, penny stocks offer an exciting way to get started. Just don’t forget to diversify your portfolio to insulate yourself against risk.

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