What Are Penny Stocks? A Complete Guide

An infographic explaining what penny stocks are, what type of risk penny stocks pose, tips to reduce the risks, and tips for finding good penny stocks.

Trading penny stocks has recently gained in popularity because of the low entry barrier and the ability to convert a little bit of money into huge gains. Penny stocks are a great way for investors who do not have the budget to invest in big-name companies. Because of the stock’s low prices, investors can buy many shares in potentially promising companies. It is possible to make a lot of money with penny stocks quickly, but it is important to know that trading penny stocks is very different from trading other stocks and carries a high risk.

To profit from penny stocks, you need to understand what they are and how they work.

What are Penny Stocks?

Penny stocks are shares of small public companies that typically trade under $5. Most penny stocks trade over-the-counter on less-regulated exchanges because the company does not have enough capital to list themselves on a reputable exchange. However, some of the higher-priced penny stocks do trade on major exchanges such as the Nasdaq. 

Penny stocks have low liquidity and low market capitalization. Most nano-cap stocks are penny stocks, and some micro-cap and small-cap stocks are penny stocks as well. 

Penny stocks have the potential to offer extremely high rewards in a short period of time. However, on the flip side, penny stocks are high-risk, speculative investments that are very volatile.

How Do Penny Stocks Work?

Small companies and start-ups generally issue stock to raise funds for their business operations. A penny stock is issued through an Initial Public Offering (IPO). Once the orders are collected, and investors buy the stock, the offering can start trading in the secondary market. These penny stocks trade on stock exchanges such as the Nasdaq, NYSE, or on the over-the-counter market. Due to the strict listing requirements of the big exchanges, penny stocks often trade Over-The-Counter (OTC).

Companies sometimes make an additional offering in the secondary market after the IPO, thereby diluting the existing shares but giving the company higher access to capital through investors. The company must continue to provide updated financial statements to the investors.

The Risks Associated with Penny Stocks

Though penny stocks provide small businesses with the necessary funding, trading these stocks poses many risks. Penny stocks rely greatly on the market conditions for their value. Here are some of the major risks:

Lack of Information

Investors sometimes find it difficult to find information on penny stocks. In addition, the available information might not come from reliable sources. Penny stock companies are not regulated like companies listed on major exchanges. This can make it difficult for penny stock investors to do the due diligence required to make informed decisions.

Illiquidity

As many penny stocks trade infrequently, there is less liquidity. Lower liquidity makes it difficult for the holders to cash out as many investors cannot sell their stocks because there are fewer buyers than sellers. As a result, the sellers might have to lower the prices to make them more attractive to other buyers. Not only could this result in losses for the investor who is trying to sell their stock, but illiquidity also increases the risk of becoming the victim of fraudulent practices.

Fraud

Low liquidity opens up opportunities for traders to enter into scams. One of the most popular penny stock scams is the Pump and Dump, where scammers buy large amounts of stocks to create inflation with the intention of attracting investors to buy these stocks. Once enough investors have put their money in them, the scammers dump their shares, resulting in an instant price drop. Investors then rush to sell their stocks and incur losses, whereas the scammers made profits.

Lack of Minimum Listing Standards 

When a company fails to maintain its position on major exchanges such as the New York Stock Exchange, it moves to a smaller over-the-counter (OTC) exchange. Large exchanges have stricter listing requirements, and a company must meet minimum financial and non-financial standards. Such standards often ensure the safety of investors.

Please note that stocks on some of the smaller exchanges, such as the OTC Pink market, formerly known as Pink Sheets, do not have to fulfill U.S. Securities and Exchange Commission (SEC) listing requirements nor the minimum standard requirements to stay on the OTC market. The OTCQB market has to adhere to listing requirements from the SEC. However, there are no minimum standards for the company to remain on the OTCQB.

Lack of History

Many companies offering penny stocks are new and have no track record. Some could even be close to bankruptcy, but investors might never find out because there are very few reporting requirements. Such a lack of background and historical information makes it hard to predict the stock’s potential.

How To Recognize Penny Stock Scams

An Infographic that explains penny stock scams, reasons why penny stocks are prone to scams, an explanation of what a pump and dump is, what offshore scams are, and what the dump and dilute scam is, and how to avoid being scammed.

It is pretty easy to manipulate penny stocks because of their low trading volumes. Penny stock companies are easy to launch, and there is a lack of regulation on smaller stock exchanges. This is why penny stocks are highly prone to investment fraud. The penny stock market is full of scams, and it is essential to recognize them and know how to avoid them.

Promoters launch a penny stock promotion in a way that makes the stock look more valuable than it is. Promoters are paid by the company that is trying to sell the stock to promote and create hype about the stock and not to provide good investment advice. They often use high-pressure techniques and try their best to convince you to buy the stock even though they might know it will not be a smart investment. Therefore, you need to spot a promotion and, if interested, do your own research. This way, you can find out if the company has actual growth potential.

Penny stock scams and frauds are much more common with online trading. Investors who use automated services to make their investment process easier often fall victim to these frauds. Online promotions target potential investors and promise enormous returns. These promotions look impressive and are often very convincing to the relatively inexperienced investor or trader. Unfortunately, there have been many cases where professional penny stock promoters have been linked to scams and lawsuits.

Here as some of the most common penny stock scams to look out for.

Pump and Dump

This is the most common penny stock scam. In this scheme, the stock price of an unknown company intentionally gets pumped up by promoters. The promoters release endless promotions that “hype up” the stock to get the investors’ attention. In these internet promotions, the readers are urged to buy the stock quickly because the promoters claim to have “inside” information that will significantly increase the stock price. 

Eventually, some of the inexperienced investors will buy the stock. This increase in demand increases the stock price and often causes a ripple effect resulting in more investors purchasing the stock. When the penny stock reaches a certain inflated price level, the scammers will sell (dump) all their stocks at a very high profit. The increased supply will cause the share price to plummet and will leave the buyers with large losses.

These promotions are often in the form of free online newsletters that target people who have recently set up new online trading accounts or have been searching for information on investing online.

​​​Dump and Dilute

This is a scheme where fraudulent companies issue stocks repeatedly for no valid reason other than wanting the investors’ money.

Usually, companies issue more shares to raise capital to improve their profitability and the value of their stock. However, in a dump and dilute case, there is no intention to use the money for company improvements. On the contrary, it will go straight into an executives’ pocket for personal use.

Share dilution happens when the number of shares outstanding increases. As a result, each existing stockholder now owns a smaller, or diluted, percentage of the company. This makes each share less valuable.

Reverse Merger scams

This can happen when a private company merges with a public company to list its stocks without going through an expensive and time-consuming IPO. Sometimes the public company is just a shell company. A shell company opens up the opportunity for the private company to falsify its financials and inflate its stock price.

Offshore Scams

Foreign companies that operate outside the United States do not have to register their stocks when selling to US investors. As a result, scammers will buy offshore stocks at highly discounted prices and then sell them at inflated prices to US investors. 

Please be aware that these scams are the most common ones. However, plenty of other penny stock scams can fool an investor into buying penny stocks that have no value.

How to Avoid Scams

Ignore promotions and promoters – One way to avoid penny stock scams is to ignore promoters and all unsolicited penny stock promotions. These promotions can come to you through phone, email, social media, or regular mail. If you believe that you have come across a reputable research report, check the disclosures section at the end of the report. If it states that the writer is being compensated by the company, steer clear from that company. It most likely is not a research report but a promotion! 

Instead of listening to the “advice” you get from these promotors, only deal with reputable investment advisers you know. 

Conduct research into the company and the management team – Another way to recognize scams is to conduct in-depth research into the company and its management team. It is always a good idea to look into the employment histories of the company’s managers. If their track records look good, then there usually is no problem. However, if there is absolutely no information available on any of the team members, or the information you find is suspect, that might be a sign not to invest in that stock.

A few other things to research are the company’s financial situation and whether its business outlook is reasonable. Often penny stock companies do not release detailed financial information. However, check the financial information they give out for large amounts of debt, available cash flow, and earnings. Also, try to find out if the company’s business plan is feasible.

Look at the quality of disclosures and which OTC tier the company is in – Another thing to pay attention to is the quality of the disclosures. The more disclosure and transparency, the better. There are 4 tiers of penny stocks based on the quality and quantity of company information available. Tier 1 and 2 companies disclose a reasonable amount of information. Tier 3 and 4 companies disclose very little or no information at all. Therefore, inexperienced investors should avoid tier 3 and tier 4 stocks at all costs. These stocks are too risky and can result in significant losses.

What it all comes down to is to conduct in-depth research yourself. You should use neutral resources to learn more about the company, its management, its background, finances, and plans.

The Advantages of Penny Stocks

Though penny stocks are high-risk investments, they do have some advantages:

  • The main advantage of penny stocks is that huge profits are possibilty from only a small investment.
  • Penny stocks are easy to start with. All you need is a laptop, an account, and an internet connection. You do not require any certification to start trading them.
  • As penny stock prices are low, even investors with a limited budget will be able to participate in these investments.
  • While good penny stocks can be difficult to identify due to the lack of available information, it is possible to find a good one by conducting in-depth research.
  • Short-selling is a great strategy to use for penny stocks. With this strategy, money is made when the stock price goes down. This is very likely to happen because penny stock companies have a high failure rate.

The OTC Market Structure

Penny stocks that trade on the major exchanges have to adhere to minimum listing requirements. These requirements include a minimum market cap and share price, as well as annual listing fees. However, most penny stocks trade on the over-the-counter markets. 

OTC markets operate differently than stock exchanges. OTC markets are decentralized markets in which two parties trade securities without a broker. All trading is electronic, and there is no physical location. Dealers are the market makers, and they quote prices at which they will sell and buy securities. As a result, OTC markets are less transparent and have fewer regulations than regular exchanges.

The OTC Markets Group is the largest U.S. marketplace for OTC securities. It divides the OTC market into 3 tiers based on the quality and quantity of company information provided to the public and the quality and integrity of a company’s operations. The markets are OTCQX, OTCQB, and Pink market. Around 11,000 U.S. and foreign securities trade in these markets. Here are details on each of these markets:

  • OTCQX, also called OTCQX best market, is the top tier. Stocks that trade on this market have to adhere to stricter requirements than stocks that trade in the other two OTC markets. The companies that issue these stocks have high average market caps and include a large number of foreign blue-chip companies. Penny stocks do not trade on this market.
  • OTCQB is the middle tier, also known as the Venture Market. Small and development-stage companies that are current in their disclosures, meet a $0.01 bid test, and are not in bankruptcy, can trade on this market. The OTCQB replaced the OTC Bulletin Board (OTCBB) as the main market for trading OTC securities that report to the SEC. The OTCQB market has no minimum financial requirements and includes penny stock companies, shell companies, and small foreign companies.
  • OTC Pink, also called Pink Sheets, is the lowest tier market and is considered a highly speculative market. It is the default market for stock traders who want to trade securities over the counter. It includes a wide spectrum of companies and companies in bankruptcy and financial distress. The OTC Pink market has no disclosure requirements. It is the largest market in terms of the number of companies and trade volume.

The OTC Markets Group often adds icons to stock listings to warn investors of concerns associated with a given company in the OTC Pink market. These icons can be a stop sign to indicate that the company cannot or will not provide important information to regulators and the market. It can also be a skull and crossbones to warn that the company might be involved in questionable promotions, scams, or criminal activity.

How to Find Penny Stocks

Finding the right penny stocks is tricky because there often is little transparency and limited company information available. There are four tiers of penny stocks based on their risk level. These tiers will help you understand the risk level you will be exposed to when investing in a particular stock. 

  • Tier 1Stocks in this tier are usually under $5 per share. They are listed on a major exchange and have to meet strict reporting requirements. Therefore, these stocks are less prone to manipulation and fraud.
  • Tier 2: These stocks are usually priced between $0.01 and $1. Sometimes stocks that trade in fractions of a penny are included in this tier as well. Some of these stocks will be listed on a major exchange if they meet the minimum listing requirements. Others will be listed on the OTC market.
  • Tier 3: Stocks in tier 3 trade below $0.01. These stocks cannot be listed on a major exchange, and do not need to adhere to any minimum requirements.
  • Tier 4: The stocks in this tier are known as “hot penny stocks” or triple-zero stocks, which means they are priced between 0.0001 and 0.0009 cents per share and benefit those who buy them first. They are the riskiest penny stocks in all markets.

Besides looking at which OTC market a potential penny stock trades in, investors can also rely on stock screeners to help them find the most profitable penny stock available. Stock screeners are filters that help you look for companies that meet certain criteria. Examples of penny stock screeners are price, performance, and volume.

Paying attention to chart patterns can be useful when evaluating stocks. An example of a chart pattern is a Price Dips. Many penny stocks have low liquidity and are very volatile. When the number of sellers outweighs the number of buyers, a stock’s price will fall temporarily because sellers have to lower the stock price to attract a potential buyer. Price Dips provide an opportunity to investors because the pattern typically reverses, and the stock price will go back up. Taking advantage of price dips is all about being in the right place at the right time.

To find penny stocks with the highest growth potential, you can use various financial ratios. Some of the most popular ratios for evaluating penny stocks are liquidity ratios, leverage ratios, performance ratios, and valuation ratios. When calculated correctly and used compared to previous periods, these ratios can help you gauge the company’s potential stock value.

In addition, you should only look for companies with solid earnings, new contracts, and a promising future.

How to Minimize Risk When Trading In Penny Stocks?

Though penny stocks offer great potential for massive gains, you always have to consider the risks.

First and foremost, when you trade penny stocks, there is no guarantee. Never invest more than you can afford to lose. You should always be prepared for the worst and invest only the amount you are ready to lose without ruining your finances.

Make sure you choose high-quality stocks from the listings in the OTCQB tier of the OTC markets. This is because this tier has standards and minimum requirements for the companies listed on it. Avoid stocks listed on Pink Sheets as they are prone to frauds and manipulation. If you invest in reputable companies, you will not only get a better return but you will also run fewer risks.

Be aware of scams and ignore promotions. Some OTC penny stocks are largely promoted but very unlikely to be successful. They often start with a high-priced IPO, aggressive promotions but are often scams.

Check liquidity and trading volumes of penny stocks before investing in them. Do your research and avoid low-liquidity stocks. For example, companies with breaking news stories often have higher trading volumes, so focus on those stocks. 

Know when to sell and remember not to over-trade. Identify the stocks you want to buy and trade when you think others will enter. Know when you should sell them, and take the small, quick profits. It is possible to make huge profits occasionally, but your money comes from these small profits that add up.

Day trading is a good strategy for penny stocks. Trade every day instead of locking your money in for longer periods.

Diversify and buy stocks in several different markets. You should invest in at least 3 or more profitable industries. Diversifying your stock portfolio is the key to minimizing your risks.

Last but not least, use limit and stop-loss orders to protect your investment. A stop-loss order is an order to automatically sell a stock once it goes below a certain price. On the other hand, a limit order sells a stock once it reaches a certain price or higher. Using these strategies will reduce your risk and limit your losses.

Are Penny Stocks Worth It?

Most penny stocks are not scams in and of themselves, and it is possible to trade penny stocks and make a lot of money successfully. However, you need to understand the risks associated with these stocks. It is very easy for scammers to take advantage of people with limited financial knowledge and experience trading these stocks. Therefore, conduct in-depth research into the company and its management so you can spot the scams and focus on the real investment opportunities.

Diversification is another way to limit risk. Penny stocks need extra caution and consideration before trading.

It is important that investors set realistic expectations when trading penny stocks and understand that the chance of making a profit is small. Investors should be prepared for potentially huge losses when adding this type of security to their portfolios and never invest more money they can afford to lose.

While penny stocks are not a great option for everybody, they can be an excellent investment opportunity with potentially massive gains and income. Try to find stable companies with a solid history, a good management team, and a realistic business plan. Invest only if you are reasonably sure that they will experience growth!

Additional reading:

https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/investor-3

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.