Penny stocks are attractive to potential investors seeking to make a small investment with the potential for a big payout. But despite the lower cost of shares compared to companies that trade on the big stock exchanges, penny stocks can be risky investments for new investors. Here's how to invest in penny stocks and some of the risks and rewards one should consider.
What are penny stocks?
Penny stocks are equity securities that often trade lower than $5 per share. The threshold for penny stocks is defined by the SEC. These stocks are usually related to small-cap or micro-cap companies. Notably, a penny stock is characterized by the stock price and not the business size.
Penny stocks trade at significantly lower prices. Therefore, an investor could hold thousands of shares by investing a small amount of money. Due to the size, the profit of only a few cents per share will translate into significant percentage returns. In 1995, for example, you could have bought Microsoft shares for less than $5 per share. In July 2020, the same shares are worth over $200 each. As a result, buying penny stocks is very tempting. However, losing a few cents per share can result in massive negative percentage returns. Beginners should not invest in penny stocks due to the possibility of losing the whole investment.
Penny stocks typically have little to no financial history or a poor one. The underlying company could be on the verge of bankruptcy. Investors can think of penny stocks as being the opposite of large-cap stocks. A large-cap stock is a huge and well-established company that has an excellent reputation. Investors struggle to sell penny stocks due to a lack of liquidity and high bid-ask spreads.
Where are penny stocks traded?
Usually, penny stocks are not traded on major market exchanges like the NASDAQ or NYSE. The big stock exchanges have listing conditions that must be fulfilled by the companies trading on them. One of the requirements is to maintain a minimum share price. NASDAQ will delist a stock if it closes below $1 per share for 180 consecutive days.
As a result, penny stocks are traded in the OTC markets—the OTCQX, the OTCQB, and the OTC Pink. The OTC markets are classified into these three categories based on the quality and quantity of the information and reports issued by the listed companies.
Stocks on these exchanges are usually related to startups and small companies. OTC exchanges generally have fewer regulations and less transparency compared to major exchanges like the NASDAQ.
Are penny stocks high risk?
Penny stocks are considered highly speculative due to the lack of liquidity and limited disclosures. Most institutional investors avoid trading in penny stocks. An investor can get trapped in a position until there is enough demand or supply to exit or enter a position.
Also, penny stock can often be part of a “pump and dump” scam due to the lack of regulations. A person buys many shares of a penny stock and then promotes and asks others to buy the stock. The price of the penny stock will likely go up if enough people buy the stock. Then, the scammer sells all of the shares for a profit. The share price will likely go down when someone dumps the shares. All of the people who bought the penny stock on the scammer’s stock tip are trapped. They hold a stock with a reduced value.
If investors are not cautious and realistic when it comes to trading in penny stocks, they could lose their entire investment.