Penny stocks are low-priced shares, usually trading below $5 per share, that are often issued by very small companies. They are often traded over the counter, or OTC, rather than on major exchanges such as the New York Stock Exchange or Nasdaq. Penny stocks can rise or fall sharply, but they also carry higher risks, including fraud, low liquidity, limited information and difficulty selling.
Penny Stocks at a Glance
| Feature | Penny stocks |
|---|---|
| Typical share price | Below $5 |
| Typical issuer | Small or early-stage company |
| Common trading venue | OTC markets, although some trade on exchanges |
| Potential appeal | Large percentage gains |
| Main risks | Volatility, low liquidity, limited information and manipulation |
| Investor profile | Speculative investors using money they can afford to lose |
Why Are They Called Penny Stocks?
The name refers to their low share prices. A penny stock does not necessarily cost one cent. In the United States, the term generally refers to an equity security trading below $5, subject to several legal exceptions.
Some securities listed on national exchanges, or issued by companies that meet certain financial requirements, may not fall under the SEC's legal definition of a penny stock.
A low share price also does not mean a stock is cheap. A company's value depends on its market capitalization, revenue, earnings, debt and future prospects. A $2 stock can be overvalued, while a $100 stock can be undervalued.
How Do Penny Stocks Differ From Microcap Stocks?
Penny stock describes a security mainly by its low share price, while microcap stock describes a company mainly by its small market capitalization.
The terms often overlap, but they are not interchangeable:
- A penny stock may belong to a company with a small market capitalization.
- A microcap stock may trade above $5 per share.
- Some low-priced stocks trade on major exchanges.
- Many microcap and penny stocks trade through OTC markets.
The SEC describes microcap companies as businesses with relatively small market values. Some have limited assets, little or no operating history, low revenue or products still under development.
Why Do Investors Buy Penny Stocks?
Investors often consider penny stocks because small price movements can produce large percentage gains.
For example, a rise from $1 to $2 is a 100% gain. The same volatility works in reverse: a fall from $1 to $0.50 is a 50% loss.
Common reasons investors consider penny stocks include:
- The possibility of rapid price increases
- Exposure to young companies or emerging industries
- A low upfront cost per share
- Speculation around a new product, merger or turnaround
- Short-term trading opportunities
The low share price does not reduce the risk of losing money. The SEC warns that investors in penny stocks should be prepared to lose their entire investment.
What Are the Main Risks of Penny Stocks?
The main risks include sharp price movements, low liquidity, limited financial information, fraud and trading restrictions.
1. High Volatility
Penny stocks can experience sharp price changes because they often have low trading volume. A relatively small buy or sell order may move the market price substantially.
2. Low Liquidity
Liquidity describes how easily an investment can be bought or sold. A penny stock with few buyers may be difficult to sell when you want to exit.
The quoted price may not be the price at which your trade is completed. A wide gap between the buying price and selling price, known as the bid-ask spread, can reduce or eliminate a potential profit.
3. Limited Financial Information
Some OTC companies provide less public information than companies listed on major exchanges. A company may have limited revenue, few assets, substantial debt or no proven business model.
With less information available, it becomes harder to assess the company's financial condition or decide whether the stock price is reasonable.
4. Fraud and Manipulation
Penny stocks are vulnerable to pump-and-dump schemes. Promoters create excitement around a stock, encourage investors to buy and push the price higher. They then sell their own shares, often causing the price to fall sharply after the promotion ends.
Warning signs include:
- Guaranteed returns or claims that a stock is "risk-free"
- Unsolicited texts, emails or social media messages
- Aggressive promotion of a specific ticker
- Unverified claims about partnerships or new contracts
- Sudden price spikes without reliable company news
- Frequent changes to the company's name, ticker or business model
- Missing or outdated regulatory filings
FINRA recommends treating unsolicited stock promotions and dramatic price movements with particular caution.
5. Possible Trading Restrictions
For many non-exempt penny-stock transactions, U.S. broker-dealers must provide a risk disclosure document, assess suitability and disclose relevant bid, offer and compensation information before completing a customer's first trade. The broker may also have to wait at least two business days after sending the disclosure before executing that first transaction.
Brokerage firms may also restrict penny-stock trading or require additional approval.
Are Penny Stocks Traded on Stock Exchanges?
Some penny stocks trade on exchanges, but many trade over the counter.
OTC securities are not subject to all the same listing standards as companies listed on major exchanges. Exchange-listed companies generally face requirements involving financial information, market value, share price and shareholder numbers.
Exchange listing does not guarantee that a low-priced stock is safe or free from manipulation.
The trading venue can affect:
- The amount of public company information available
- The number of buyers and sellers
- The size of the bid-ask spread
- The ability to execute an order
- The company's reporting obligations
How Should Investors Research a Penny Stock?
Before considering a penny stock, review the company instead of relying on its share price or online promotion.
Check the following:
- The company's SEC filings: Look for revenue, cash, debt, losses, share dilution and warnings about the business.
- The business model: Determine what the company sells and how it expects to make money.
- The trading volume: Low volume can make buying and selling difficult.
- The bid-ask spread: A wide spread increases trading costs.
- Share dilution: New share issuance can reduce existing shareholders' ownership percentage.
- Company management: Review executive backgrounds and previous business ventures.
- The source of the recommendation: Treat unsolicited online tips, chat-room promotions and social media claims cautiously.
- The company's OTC disclosure status: Limited information generally means greater investment risk.
FINRA recommends researching how the company makes money, reviewing reliable financial information and avoiding decisions based only on online posts or promotional material.
Are Penny Stocks a Good Investment?
Penny stocks are generally unsuitable for investors seeking stable, diversified or long-term investments. They are speculative securities that can produce large losses, including the loss of the entire amount invested.
Penny stocks may suit experienced investors who understand liquidity risk, volatility, dilution, company-specific risk and manipulation, and who use money they can afford to lose. For most investors, diversified mutual funds or exchange-traded funds offer a more practical way to gain stock-market exposure without relying on one small, thinly traded company.