Penny stocks are a class of low-price, high-risk public companies. They tempt highly speculative traders with the illusion of easy exponential growth, offering the chance to double, triple or quadruple their money.

What Is a Penny Stock?

A penny stock typically refers to the stock of a small company that trades for less than $5 per share. Though some penny stocks trade on large exchanges such as the New York Stock Exchange (NYSE), most trade via over-the-counter (OTC) transactions through the electronic OTC Bulletin Board (OTCBB) or through the privately-owned OTC Markets Group.

There is no trading floor for OTC transactions. Quotations are also all done electronically.

Typically, penny stocks represent shares of companies that are either start-up stage or have yet to establish a significant lead in their industries. That doesn’t mean penny stocks are bad, however. In many cases, these companies are focused on cutting edge innovation. This is why traders and investors alike will buy them based on speculation instead of general fundamentals.

The obvious attraction to trading penny stocks is making money quickly. Not only that but because of the inherent volatility, these cheap stocks can see massive rallies of 100% or more within a single day. This is what is so attractive for investors and the crazy part is, sometimes traders won’t even know what they’re buying. They just focus on a penny stock’s symbol. Here’s where a good understanding of trading comes into play. You have things called catalysts that act as a trigger for penny stock breakouts.

Knowing what the catalyst is and what traders are paying attention to in order to develop their trading strategy is important. It’s very easy to get caught up in the hype and lose all of your money; possibly more if you use margin. So this is why it’s so important to know how to trade penny stocks and what to watch before hitting the buy button.

KEY TAKEAWAYS

• A penny stock refers to a small company's stock that typically trades for less than $5 per share. 

• Although some penny stocks trade on large exchanges such as the NYSE, most penny stocks trade over the counter through the OTC Bulletin Board (OTCBB).

• While there can be sizable gains in trading penny stocks, there are also equal risks of losing a significant amount of an investment in a short period.

What Is Over-the-Counter (OTC)?

Over-the-counter (OTC) is the process of trading securities via a broker-dealer network as opposed to on a centralized exchange like the New York Stock Exchange.

Over-the-counter trading can involve stocks, bonds, and derivatives, which are financial contracts that derive their value from an underlying asset such as a commodity.

When companies do not meet the requirements to list on a standard market exchange such as the NYSE, their securities can be traded OTC but may still be subject to some regulation by the Securities and Exchange Commission.

KEY TAKEAWAYS

• Over-the-counter (OTC) securities are traded without being listed on an exchange.

• Securities that are traded over-the-counter may be facilitated by a dealer or broker specializing in OTC markets.

• OTC trading helps promote equity and financial instruments that would otherwise be unavailable to investors.

• Companies with OTC shares may raise capital through the sale of stock.

Risks of Penny Stocks

While you might think the risks are low when prices are also low, penny stocks tend to carry much higher risk than stocks that trade on major exchanges. This makes it easier to lose money, no matter what the size of your investment.

High Price Volatility

Because penny stocks have low prices, “just a small move in the stock price can represent a large percentage gain,” says Tyler Hardt, chartered financial advisor (CFA) at Pelican Bay Capital Management.

A move from $0.50 a share to $1.00 a share might not look like much at first glance, but it’s a 100% gain. But by the same token, when things go bad, they go bad fast. A small absolute loss could represent a significant percentage loss.

Most investors can’t handle that much volatility.

Unproven, Opaque Companies

Penny stocks are usually lesser-known companies without proven track records. They may have lower reporting requirements, making it difficult to adequately research them before investing.

With more mainstream stocks, investors can pop the hood, get plenty of financial data other required reporting to see how companies have performed. With penny stocks, you may be buying blind or be forced to invest large amounts of time researching them.

Low Trading Volume

When you buy stock on the Nasdaq or the NYSE, there is a very large market filled with buyers ready to purchase any amount of shares. If no single buyer wanted all your shares, a brokerage or market maker would take your stock because they know they’ll be able to find buyers later.

Things are different with penny stocks, whether they’re listed on major exchanges or traded OTC. Trading volumes in penny stocks are very low, with few buyers or market makers.

“Even if that stock you bought for $0.10 is now worth $0.75, you can’t sell it unless there is another investor who is willing to buy it from you,” says Simpson. You may be making profits on paper with penny stocks, but you might not be able to realize your gains.

OTC Penny Stocks, NASDAQ Penny Stocks & NYSE Penny Stocks; Do You Know The Difference?

Many of the reasons traders will stray away from things like OTC penny stocks has a lot to do with reporting requirements. This refers to the company’s responsibility to put out timely information through the submission of public filings to the SEC. Today, there are different tiers of the OTC, each with its own minimum for publicly available information. However, there are also minimum price requirements as well.

When it comes to NASDAQ and NYSE penny stocks, the exchanges will require the companies to keep their prices above $1. In the event shares dip below that level, the exchange may end up delisting that penny stock, which would then trade on the OTC.

Are OTC Penny Stocks bad? No, they aren’t “bad” but you should understand that you may need to do a bit more research before buying them. Understand what the company does, when it last released news, is there a business plan and a clear end game. Things like this can help you sift through the best penny stocks to buy and ones to avoid.

Then again, the same holds true for NYSE and NASDAQ penny stocks. Even though they may be “listed on a major exchange” it doesn’t mean they’re the best penny stocks to buy.

Penny Stocks Check-List

Make sure you run them through the same penny stocks checklist:

Penny Stocks Check-List

1. What was recently announced and how long ago was it reported

2. Are they making timely filings and disclosure statements available

3. Does the company have a clearly thought out business plan

4. Are they communicating with shareholders frequently (IE if they just put out news, when was the last press release prior to that)

5. How is the company staying afloat (Are they constantly raising money or are they generating profit, etc.)

The Impact of Social Media on Penny Stocks

The stock market is always changing and new trends are being identified. Since 2020, we’ve seen the impact of social media on penny stocks. It has certainly played a larger and more profound role. 

You might remember the GameStop (NYSE: GME) explosion that occurred at the beginning of 2021. While this was in no way the first time social media had an impact on how stocks trade, it did set in motion a new trend for investors to use. As it relates to GME, many traders came together on Reddit, discussing a company that they had an emotional connection to.

This led to hoards of people investing in the stock, and the price subsequently rose in the four-digit percentage range in a very short period. 

This phenomenon is no a regular occurrence. Reddit, Twitter, Facebook and even TikTok are hotbeds for meme stock hype. While this excitement can relate to news, it often has more to do with investors discussing the stock based on speculation than fundamentals. 

Yes, fundamentals are always crucial to consider. However, it’s also important to check factors such as volume and what is being said online. Because penny stocks are extremely speculative, prices can move very quickly. If you are putting certain stocks on your watch list because you read about it on social media, please make sure to do as much additional research as possible to come to your own conclusion on whether you should trade them or not.

Understanding Penny Stocks

In the past, penny stocks were considered any stocks that traded for less than one dollar per share. The U.S. Securities and Exchange Commission (SEC) has modified the definition to include all shares trading below five dollars. The SEC is an independent federal government agency responsible for protecting investors by maintaining the proper and orderly functioning of the securities markets.

Penny stocks are usually associated with small companies with a lack of liquidity, meaning that there are few ready buyers in the marketplace. As a result, investors may find it difficult to sell stock since there may not be enough buyers. Because of the low liquidity, investors might have difficulty finding a price that accurately reflects the market.

Due to their lack of liquidity, wide bid-ask spreads or price quotes, and small company sizes, penny stocks are generally considered highly speculative. In other words, investors could lose a sizable amount or all of their investment.

Advantages of Penny Stocks

Due to their low volume, penny stocks tend to be more volatile than established equities. This means high opportunities for both gains and losses, and investors should be careful to understand both the risks and benefits.

Funding for Small Companies

Penny stocks do provide some small businesses with a way to access funding from the public. These companies may use this platform as a starting block to move into a larger marketplace.

High Potential for Growth

Also, since they sell at such low prices, there is room for significant upside. Some companies, such as Amazon (AMZN) originated as penny stocks but later grew into sizable blue-chip companies.

A blue chip is a nationally recognized, well-established, and financially sound company. Blue chips generally sell high-quality, widely accepted products and services. Blue-chip companies typically have a history of weathering downturns and operate profitably in the face of adverse economic conditions, which helps to contribute to their long record of stable and reliable growth.

Pros

• Offer a place for small companies to gain access public funding.

• In some cases, penny stocks may provide a method to gain access to larger marketplace listing.

• With a lower price, penny stocks allow for significant upside in share appreciation.