What are penny stocks?

How penny stocks work

The term “penny stock” typically refers to stocks of smaller publicly traded companies whose share price is under $5. Some of these companies are available through public exchanges, but many are traded over-the-counter (OTC) through online marketplaces.

Penny stocks are also known as “microcap” stocks, as their market capitalization is typically much smaller than more stable publicly traded companies.

Penny stocks are characterized by their relative lack of liquidity, meaning there are fewer available buyers and sellers of the stock, and the listed price may not be the price you end up paying. Large purchases or sales of penny stocks can quickly swing stock prices, and the lack of liquidity can cause very wide bid-ask spreads.

Penny stocks are known to be ripe with fraud and scammers who manipulate the market as a means of profit for themselves, causing investors to lose large sums of money in the process.

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Investing in penny stocks: opportunities and risks

Penny stocks are tempting to investors who are looking for a large upside with a relatively small investment. But the volatility of penny stocks also means prices can fall quickly and losses can mount up faster than a larger company stock.

The upside to penny stocks is the ability to see large percentage gains in a short amount of time. For example, if you buy a penny stock that’s listed for $1 per share, and sudden demand for the stock boosts the price to $1.50 per share, you just made a 50% gain. This can happen within a matter of days or even hours.

But the downsides to penny stocks are many, including:

• Extreme volatility: The attractive part of penny stock investing is also a risk. Prices can plummet 90% (or more) in a matter of hours or even minutes, and if you’re not protected with a stop-loss order or watching closely, you can lose most of your invested funds quickly.
• Lack of liquidity: Even if you get a penny stock at a great price and it doubles in value, you may have a tough time selling it. This is because there may not be many buyers available, and the price you want to sell it at won’t have any takers. This lack of liquidity can cost you a huge chunk of your gains.
• Scams: Penny stocks attract scammers. One of the most popular scams is the “pump-and-dump” scam. Investors accumulate a large amount of a particular penny stock and then, through influencers or their own reach, hype up the company and stock, causing a surge in demand. As the price spikes, scammers sell their position at the highest prices. Eventually the price plummets, causing many investors to lose money.
• Fraud: The promise of quick wealth causes many fraudsters to tout penny stocks as an investment that can make someone rich. But through sophisticated scams, investors can send money to someone who doesn’t invest it for them and simply steals client funds. The FBI reported that millions of dollars have been lost to these scams.
• Regulatory concerns: There is less scrutiny and public information required from penny stock companies, especially those that aren’t traded on national or regional stock exchanges. And penny stocks listed only through private OTC brokers aren’t required to file with the Securities and Exchange Commission (SEC), so there is less regulatory oversight and consumer protection available.

Alternatives to penny stocks

While penny stocks may still be a good choice for speculative investors who understand the risks involved, there are other types of trading available that may offer similar rewards (and risks):

• Cryptocurrency: Cryptocurrency suffers from many of the same downsides as penny stocks (liquidity, scammers, lack of regulation), but if you are a fan of penny stock volatility, crypto may offer a similar experience. Just remember that it’s 100% speculation and you can lose all of your money invested.
• Options trading: Trading options contracts can offer similar upsides (and risks) as penny stocks, but it’s a bit more regulated. You may need more upfront cash, but you can enjoy high potential upsides. This is an advanced trading technique, though, so make sure to do your research.
• Leveraged trading: If you want the potential for larger gains, you may be able to trade with margin, giving you leverage on your regular stock trades. Again, this is high risk, high reward, but leveraged trading of more common (and liquid) stocks can be a great alternative to penny stocks.

Investing in penny stocks can be fun for a small percentage of your net worth, as long as you understand the risks involved and stay protected, but long-term, it’s not a great investment strategy. Active traders typically underperform simple index funds over time, and penny stock traders may fare even worse.

If you’re looking for low prices on good investments, you may consider investing in exchange-traded funds (ETFs) that offer lower prices for many popular index funds and other investments, or using an investment app, such as M1 Finance, that allows you to buy fractional shares of stocks.

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Should you ever invest in penny stocks?

Investing in penny stocks is a speculative strategy with very high risks but also high potential rewards. With so many negatives, is it ever OK to invest in penny stocks?

Your best bet to avoid the drastic losses that many penny stock investors encounter is to do your research and invest only small amounts of money you are willing to lose. This includes setting limit orders and stop-loss orders so that you aren’t impacted too heavily by massive price fluctuations. And put together a trading strategy, journaling each trade to take the emotion out of your investment strategy.

Investing in penny stocks is speculative and akin to gambling. It can be a fun form of entertainment that may make you a few dollars, but don’t bank your retirement on getting rich from trading penny stocks.

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Bottom line

Penny stock investing is speculative, with the ability to secure high returns but with an equal (or greater) risk of losing money. Investing in penny stocks should come with a huge helping of discretion, and you should only invest money you are willing to lose. Not all penny stocks are bad, but if you plan on actively trading penny stocks, expect that some trades will not turn out the way you want.

For long-term investors, penny stocks are simply a distraction, and sticking to a well-diversified portfolio of index funds may serve you better.