A penny stock is the stock of a small company that trades for less than $5 per share. Some penny stocks are traded on large exchanges such as the New York Stock Exchange (NYSE). But mostly, quotations and trades occur via over-the-counter transactions, the over-the-count Bulletin Board or through the privately owned over-the-counter Markets Group.
As they are generally associated with small companies, penny stocks typically have low liquidity. Which can make it harder for investors to sell their penny stocks or find a price that accurately reflects the market.
Taking these factors into account, penny stocks are often considered to be highly speculative, meaning that investors could stand to lose a substantial amount or even all of their investment should the market turn on them.
How penny stocks work
Penny stocks essentially trade just like any other stock but can carry added risk. Low liquidity and vulnerability to price swings contribute to the sentiment that penny stocks can be a risky investment.
Given the small nature of the companies and less coverage from large institutional investors, penny stocks offer less information for investors to help them make informed decisions.
As an illiquid stock, penny stocks are often subject to price manipulation. This is when an investor buys large quantities of a stock and artificially inflates the share price through false or misleading positive statements, in the world of investments this is known as pump and dump.
Historically penny stocks were stocks that traded for less than $1 per share, but the Securities and Exchange Commission redefined them to include all shares trading below 5 dollars.
Penny stocks are created by small companies and startups as a way of raising capital to help them grow the company. Just like other types of publicly traded stock, penny stocks are created through an Initial Public Offering (IPO).
Before they can be listed on the over-the-count Bulletin Board, the company must file a registration statement with the Securities and Exchange Commission or they must file stating the offering qualifies for an exemption from registration.
Once approved, the company can then begin selling penny stocks, it can apply to sell on a larger exchange or it can trade on the over-the-counter market.
Advantages of penny stocks
The advantages of penny stocks include:
Potential for high returns
All companies have to start somewhere and there are many good companies trading penny stocks. Backing startups from the very beginning could potentially lead to high returns in the future if the company increases its market share or takes over an industry.
Do more with less
Given their small share price, investors can buy more penny stocks for their money. If the return on these stocks is good, it may open up opportunities for investment in larger stocks on the wider market.
Gains can be quick
While this is not true for all penny stocks, the ones that do see quick action in their market price tend to see it quickly. Penny stock prices can rise rapidly within days, so the potential gains can be rapid.
Disadvantages of penny stocks
The disadvantages of penny stocks include:
Tend to be low-quality stocks
The majority of penny stocks come from low-quality companies. The product or service they offer may be in an inactive industry or it may be flooded with competitors which can affect the growth of the company.
Just as the gains can be big, so can the losses. Being illiquid stocks, penny stock investors often lose some if not all of their initial investment. While this is not always the case it is important to consider when investing in penny stocks.
Penny stock markets are often highly volatile, big price movements can happen quickly. This is great when it is in an investors favor, but could result in big losses if not.