Yes. Penny stocks are among the highest-risk publicly traded investments. They can experience extreme price swings, have limited trading volume, provide less reliable information, and may attract fraudsters. Investors can lose some or all of their investment.
Penny stocks are not automatically scams, and some represent legitimate small businesses. Their risk is generally much higher than the risk of established companies listed on major exchanges.
Penny Stock Risks at a Glance
| Risk | Why it matters |
|---|---|
| Total loss | A small company may fail, leaving common shareholders with little or nothing. |
| High volatility | A small trade can cause a large percentage move in the share price. |
| Low liquidity | You may not find a buyer when you want to sell, or you may need to accept a much lower price. |
| Limited information | Some companies provide less financial and operational information than established public companies. |
| Fraud and manipulation | Thinly traded stocks can be used in pump-and-dump schemes. |
| Reverse splits | A company may consolidate shares to raise its quoted price without increasing its underlying value. |
What Is a Penny Stock?
In the United States, penny stocks are generally low-priced shares that often trade below $5 per share. Many trade over the counter rather than on exchanges such as the New York Stock Exchange or Nasdaq, although some low-priced stocks trade on exchanges.
"Penny stock" and "microcap stock" are related terms, but they do not mean the same thing. A penny stock is usually identified by its low share price. A microcap stock is associated with a very small market capitalization. The categories overlap, but not every penny stock is a microcap stock, and not every microcap stock trades below $5.
A low share price does not mean that a stock is cheap. A company with a $0.50 share price may be more expensive relative to its business than a company with a $100 share price. The comparison depends on factors such as shares outstanding, revenue, assets and debt.
Why Are Penny Stocks So Risky?
1. Penny Stocks Can Be Difficult to Sell
Liquidity measures how easily an investment can be bought or sold without substantially changing its price. Penny stocks often trade in low volumes, which can make it difficult to sell shares quickly. A large sell order may push the price down sharply, and there may be few buyers available.
This creates a risk that is less common with heavily traded companies such as Apple or Microsoft. You may see a quoted price for a penny stock but still be unable to sell a meaningful number of shares at that price.
2. Prices Can Move Sharply
Low trading volume can make penny stocks unusually volatile. A relatively small number of buy or sell orders may cause a large percentage change in the share price. The price can rise quickly on publicity or speculation, then fall when buyers disappear.
Volatility can produce a large gain, but it can also lead to a rapid and substantial loss.
3. Company Information May Be Limited
Many microcap companies are new, have limited operating histories, or have little revenue, few assets or products still under development. Some over-the-counter companies also provide less public information than companies that file regular reports with the Securities and Exchange Commission.
Without current financial statements and clear information about the business, investors may struggle to assess:
- Whether the company generates revenue
- How much cash the company has
- How much debt it carries
- Whether management has relevant experience
- How many shares the company may issue in the future
- Whether the company has a viable product or service
4. Penny Stocks Can Be Manipulated
Thinly traded stocks are easier to manipulate because a small number of traders can have an outsized effect on the price or trading volume. In a pump-and-dump scheme, promoters create excitement around a stock, encourage others to buy, and then sell their own shares into the demand. The price often falls after the promotion ends.
Be cautious about unsolicited recommendations received through:
- Social media
- Text messages
- Online chat rooms
- Email newsletters
- Anonymous investment forums
- Cold calls from unknown promoters
A sudden price increase without a clear business reason is a warning sign. It is not proof that the company is about to grow.
5. A Company Can Lose Money or Become Worthless
Shareholders are last in line if a company fails and its assets are liquidated. Creditors and certain other claimants are paid before common shareholders, and there may be nothing left for investors. The SEC states that investors in penny stocks should be prepared to lose their entire investment.
A stock does not need to be fraudulent to lose most or all of its value. Business failure, a failed product, insufficient funding, regulatory problems or bankruptcy can produce the same result.
6. Reverse Splits Can Disguise a Falling Share Price
A reverse stock split reduces the number of shares and increases the quoted price per share. In a 1-for-100 reverse split, an investor with 10,000 shares would receive 100 shares. The total value would initially remain approximately the same.
A reverse split does not create business value. FINRA states that reverse splits frequently occur among low-priced, high-risk stocks, particularly OTC companies.
Are All Penny Stocks Bad Investments?
No. Some penny stocks are legitimate companies with real products, employees, revenue and growth prospects. Legitimacy does not remove the risks created by low liquidity, high volatility and limited information. FINRA describes low-priced securities as speculative investments that should generally be purchased only with money an investor can afford to lose.
An exchange listing does not guarantee safety. A low-priced stock listed on Nasdaq or the NYSE may still face financial problems, possible delisting or extreme volatility. Exchange listing standards can provide more information and oversight, but they do not make an investment safe.
How to Assess a Penny Stock Before Buying
If you are considering a penny stock, review the following before placing an order:
- Check SEC filings. Search for the company in the SEC's EDGAR database and confirm whether it files current financial reports.
- Read the latest financial statements. Review revenue, cash, debt, operating losses and cash burn.
- Review trading volume. Low volume can make it difficult to buy or sell without moving the price.
- Check the bid-ask spread. A wide spread increases the cost of entering and exiting the position.
- Investigate promotions. Treat claims of guaranteed returns, secret breakthroughs or imminent price targets as warning signs.
- Look for reverse splits or frequent share issuance. These actions may indicate financial pressure or a need to raise more capital.
- Avoid using essential money. Do not use emergency savings, rent money or funds needed for retirement expenses.
The SEC also requires brokers to provide a penny stock risk disclosure statement for certain transactions, obtain the investor's agreement and, in applicable cases, wait at least two business days before executing a first transaction. These rules provide warnings, but they do not make the investment safe.
Bottom Line
Penny stocks are high risk and are usually unsuitable as a core investment for beginners or long-term investors. Before buying one, assess its liquidity, financial strength, disclosure quality, business viability and exposure to manipulation.
If you choose to trade penny stocks, treat them as speculative investments, limit the amount at risk and assume that you could lose the entire position.