What Are Penny Stocks?

Stocks trading for less than $5 come with potential and lots of risk

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If you don’t have a ton of money but still want to invest in stocks, ultra-cheap stocks, or “penny stocks” might seem appealing.

Most of these stocks don’t actually cost a penny, of course. The term “penny stocks” generally refers to any stock trading at less than $5 per share. They may also be known as micro-cap or nano cap-stocks. You can buy them at many large and small online brokerage firms.

These stocks are often traded very infrequently, and the companies may be troubled, new to the markets, or re-emerging from bankruptcy. 

While some investors may make good money trading penny stocks, they are considered speculative investments, due to the volatility of prices and lack of information . Moreover, the penny stock market has historically been rife with fraud.

A History of Penny Stocks

As long as there have been publicly traded companies, there have been penny stocks. They became “official” after the passing of the Securities and Exchange Act of 1934, which established an accepted definition of penny stocks, and outlined how they should be traded. 

The SEC brought some order to the trading of stocks, and penny stock brokers emerged as a result. But in the early days, trading penny stocks was not as easy as it is now, due to the limitations of communication. 

By the 1980s, however, investors were trading billions of dollars in penny stocks, though many were victimized by scams. This led to the passage of the Penny Stock Reform Act of 1990, which expanded the SEC’s power to regulate penny stocks. 

Penny stocks sometimes trade on large exchanges like the New York Stock Exchange (NYSE). More commonly, though, they trade on over the counter (OTC), or “pink sheet” exchanges—the Over-the-Counter Bulletin Board (OTCBB), which trades penny stocks that generally adhere to U.S. regulatory reporting standards, and the OTC Markets Group, or Pink Sheets, which don’t.

The Potential of Penny Stocks

If the company is legitimate and operating in good faith, it may be possible to make large profits on penny stocks. 

Think about this: If a stock is trading at $2 and rises to $4 within a month, you’ve doubled your investment in a short period of time. If a stock is trading at $50, it will likely take much longer to bring you the same kind of return. 

The problem is that a penny stock could drop in value just as quickly, leaving you with a sizable loss. And the smaller penny stocks, in particular, have historically been much more volatile than the shares of larger companies.

The SEC notes that because these stocks are so thinly traded, they can be hard to sell once you buy them, and pricing them accurately can be very difficult. 

More Reasons to Have Caution

In addition to their inherent risk, penny stocks are notoriously subject to scams. In “pump and dump” scams, someone buys shares of very cheap and thinly traded stocks and then hypes them up through advertisements via email or social media, only to sell the shares quickly after seeing share prices rise. In some cases, these companies have been found to be nothing more than the dormant shells of bankrupt firms. 

The Financial Industry Regulatory Authority (FINRA) says that investors should be on the lookout for companies that were dormant and then came back to life, as well as firms that had numerous changes to their name or business focus. Unusual reverse stock splits are also a red flag, according to FINRA. 

Penny Stock Pros

  • Can invest small amounts of money

  • Potential to invest in new, exciting companies

  • Potential to see big returns in a short amount of time

Penny Stock Cons

  • The stocks are often thinly traded

  • Many of the companies are troubled

  • Prices tend to be volatile

  • Potential for large losses

  • Long history of scams

Who Should Invest in Penny Stocks?

Penny stocks generally trade for less than $5 per share, which may be affordable to the beginner investor. At that price point, an investor may see an opportunity to buy several shares of a young, trustworthy company. There’s always the opportunity to earn or lose money on your investment, but a penny stock investor, in particular, will need a high tolerance for risk. With the right company, capital, and risk tolerance, an investor could make out well in penny stocks. 

The Bottom Line

Penny stocks can offer investors the potential to make money, but regulators and brokers advise people to enter this space with caution. Due to the low trading volume of penny stocks, pricing can be hard to pin down accurately and may be subject to wild swings. They are also often subject to scams.

Most investors, particularly those with a long-term outlook, may make out just fine avoiding penny stocks altogether. 

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

Article Sources

  1. Securities and Exchange Commission: Penny Stock Rules 

  2. Securities and Exchange Commission: Microcap Stock: A Guide for Investors

  3. U.S. Securities and Exchange Commission: Outcomes of Investing in OTC Stocks

  4. Congress.gov: Securities Enforcement Remedies and Penny Stock Reform Act of 1990

  5. FINRA: Unregistered Penny Stocks Can Spell Big Problems 

  6. South Carolina Attorney General Alan Wilson: Penny Stock/Microcap Stocks

  7. The Financial Industry Regulatory Authority: FINRA, SEC Warn Investors About Penny Stock Scams Hyping Dormant Shell Companies 

  8. Missouri Secretary of State: Penny Stocks