Penny Stocks: What are they and do they make good investments?

What Are Penny Stocks

Penny stocks are low-price shares in smaller companies that are popular with some retail investors. Despite the name, penny stocks are usually considered to be any stock that trades at less than $5.

They might have a lower stock price than major companies but penny stocks are highly risky investments. Some investors enjoy the potential excitement of investing in smaller companies in the hope of cashing out when they make it big. But betting on penny stocks might also leave you with just pennies left or none at all.

Table of Contents

  1. What are penny stocks?
  2. Risks of penny stocks
  3. Should you invest in penny stocks?
  4. Alternatives to penny stocks
  5. Have you considered OTC stocks, instead?

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What are penny stocks?

Penny stocks are common shares of small public companies that trade at low prices and are usually sold outside major exchanges. Here are some of the common characteristics of penny stocks:

  • Low-price: The U.S. Securities and Exchange Commission (SEC) defines penny stocks as any stock that isn’t listed on a national exchange and trades for under $5, but some penny stock investors use $1 as their limit.

  • Small companies: These stocks are usually associated with smaller companies and are therefore referred to as “micro-cap” stocks. Definitions vary, but micro-cap stocks tend to be shares in companies with market capitalizations of between $50 million and $300 million.

  • Over-the-counter: Most penny stocks are sold over-the counter, either on the pink sheets or over-the-counter bulletin board (OTCBB). Many investors and brokers also consider larger over-the-counter stocks to be penny stocks, regardless of their share price or company size.

  • High potential, high risk: Penny stocks are considered very risky securities due to minimal oversight and low liquidity. However, since they sell for such low prices, there also is potential room for growth.

Risks of penny stocks

Penny stocks are considered to be highly risky secondary-market investments, especially compared to blue-chip stocks. Most financial advisors see penny stocks as highly speculative, meaning investors could lose a significant amount of their investment.

Here are a few of the major risks to consider when looking at penny stocks:

  • Low liquidity: Penny stocks have a lack of liquidity compared to blue chip stocks sold on the New York Stock Exchange (NYSE) or Nasdaq, which means they may face high volatility. It also opens up the opportunity for some traders to manipulate stock prices, particularly through pump-and-dump schemes.

  • Lack of publicly-available information: Companies with penny stocks tend to be newer, which means they may not have track records and it can be difficult for investors to assess how the company is truly performing. Micro-cap stocks also sometimes are approaching bankruptcy, making them highly risky investments.

  • Limited reporting requirements: Companies listed on OTC markets don’t have the same regulatory requirements as those on major exchanges. This includes many penny stocks, which may have moved to OTC markets to avoid these requirements.

  • Potentially unprofitable: Low liquidity can make it difficult to turn a profit on penny stocks if it becomes difficult to get out of the position. In fact, many advisors consider penny stocks to be speculative investments due to the high risk of losing your investment. If you invest with Public, you’ll see safety labels on risky stocks so you can make informed investment decisions.

  • Fraud: Micro-cap stocks are common targets for scammers, thanks to minimal reporting requirements and low liquidity. Common scams include paid recommendations that direct users to specific stocks, and offshore brokers that resell these stocks at much higher prices than they’re worth.

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Should you invest in penny stocks?

Penny stock trading is considered high-risk but that doesnt necessarily mean you should avoid them entirely. As with any investment decision, its important to do your research and determine whether the company is a good fit for your investment strategy. They may not be appropriate for investors who are conservative or have short-term needs as they come with risk and potential loss of the investment.

While scams and fraud occur outside of the penny stock market, there are some specific risks that come with penny stocks. Here are some suggestions for mitigating those risks:

Figure out how much you can lose

Since penny stocks are highly speculative, its helpful to consider how much youre willing to lose if your investment doesnt work out. Ensuring that you have a diversified portfolio that matches your personal risk tolerance and goals is a key part of investing. Day trading has the potential to turn a profit, but often it can do the opposite; large-cap equities tend to offer steadier long-term returns.

Do your research

It can be difficult to find reliable information on the best penny stocks, but it can help to look at the financial information that does exist. The more information a company provides about its track record, the greater transparency it offers. Looking at the balance sheet for signs of significant debt or malpractice.

Its also important to understand the difference between promotional material and research. A common penny stock scam involves promoters who pay newsletters to write reports that portray their stock positively. These reports may look legitimate but they may be paid promotions.

Editors Tip

  • One way to identify promotional material is to look for disclosures at the end of the report. If the writer is being compensated (either in cash or with stock) by the company they’re promoting, it’s an advertisement.

Keep an eye out for fallen angels

Fallen angel stocks are in industries that experience cyclical downturns. Sometimes, companies that are otherwise strong start to struggle. Some investors choose to purchase stocks in these penny stock companies in the hopes that future performance will increase their investment.

Editor's tip

  • Look out for the letter “Q” at the end of a stock ticker. When this is added to the ticker, it most likely means the company is in bankruptcy.

Alternatives to penny stocks

The bottom line is that penny stock trading isnt the best fit for every investor. If penny stock investing doesnt sound right to you, there are a host of other securities you can invest in on Public. Many of these investments come with lower risks and less volatility than penny stocks.

Some common alternatives to penny stocks include:

  • OTC stocks: Investors looking for alternatives to the stock market sometimes turn to OTC stocks. While penny stocks are usually sold OTC, there are many well-established companies that also sell their stock this way. When you trade over-the-counter, you can also get access to larger companies like Tencent, Softbank, or Nestle that aren’t listed on major U.S. exchanges directly from Public.

  • Low-price stocks on major stock exchanges: There are plenty of stocks priced under $5 on the Nasdaq and New York Stock Exchange (NYSE). The trading volumes on these exchanges tends to be higher and, since companies are held to strict reporting requirements, the risk of scams tends to be lower.

  • Fractional shares: If penny stocks appeal because of their low share prices, fractional share investing could be an alternative. Public lets you purchase a slice of a stock instead of the whole thing, so you can own pieces of more expensive stock. You can trade fractional shares the same way you would with whole shares.

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Have you considered OTC stocks, instead?

If youve decided you want to buy a particular penny stock, or want to invest in other OTC securities, you can likely find them on Public. Heres how you do it:

  1. Find the company: Ensure you have enough money in your brokerage account and search for the company’s ticker symbol on Public. There are more than 300 OTC securities available on the site, so there’s plenty to choose from.

  2. Select the number of shares you want to buy: Enter a whole number of shares and purchase the security during normal trading hours. Public doesn’t currently allow after-hours trading or fractional investments in OTC securities.

  3. Choose limit order or market order: Public-facilitated OTC trades default to limit order but can be adjusted to market order.

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FAQs

What are penny stocks?

Penny stocks are small companies whose shares trade for less than $5 each. They may look cheap but often come with significant risks.

How to find penny stocks?

You’ll find penny stocks on Public through over-the-counter markets or on major exchanges. You can trade them using your investment account the same way you would any other stock.

How to buy penny stocks?
    Open an investment account with a brokerage like Public.
    Do your research to avoid scams.
    Check the stock’s volume.
    Start small and diversify.
Are penny stocks risky?

Penny stocks are some of the most risky stocks and there’s a chance you’ll lose all of your investment. They’re less liquid, tend to have small market caps, and many companies are unproven or facing hardship

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