What Is a Penny Stock?
A penny stock, which is more formally known as a microcap stock, is a share of a company that typically has a market capitalization of less than $300 million. Nanocap stocks, also a type of penny stock, are issued by companies that typically have a market capitalization of less than $50 million. Penny stocks usually trade for less than $5 per share.
With the surge in online trading among retail investors, interest in penny stocks has grown. But while they may be “cheap,” these securities have significant pitfalls of which to be aware, including the allure of enormous upside potential.
Definition and Examples of Penny Stocks
Penny stocks are stocks that typically trade for less than $5 per share. If the company has a market capitalization of less than $300 million, it is typically considered a penny stock.
- Alternate names: microcap stocks, nanocap stocks
For example, in February 2020, Eastside Distilling (EAST), a distillery in Portland, Oregon, traded at around $2 a share and its market cap was about $21 million. Because of its market cap and share price, it would be considered a penny stock.
How Penny Stocks Work
Some investors are drawn to penny stocks because their low price allows them to purchase a large number of shares. But a low price also opens the door to large swings in value, creating an opportunity for significant gains—or significant losses.
The very characteristics that make a penny stock a penny stock also make them riskier investments than stocks of larger companies.
Pros and Cons of Penny Stocks
Affordable share prices
Potential for significant increases in value in a short period of time
Can trade with most brokerages
Often less publicly available information about the company
Price is highly volatile
Low liquidity, which means they can be difficult to sell
More susceptible to price manipulation through fraudulent or other activity
Subject to less criteria and scrutiny than companies with shares on major exchanges
Where Do Penny Stocks Trade?
Although some penny stocks trade on large exchanges such as the New York Stock Exchange (NYSE) or the Nasdaq, many penny stocks trade on the over-the-counter (OTC) market. You can find quotes for penny stocks on a website like OTC Markets, which offers information for almost 12,000 securities traded on three markets.
OTC Markets also provides news and research capabilities for penny stocks, including a stock screener that searches based on criteria you select, such as past performance, country, and industry.
Penny Stocks vs. Small-Cap Stocks
Investors should be clear about key differences between penny stocks and small-cap stocks. Penny stocks are generally riskier and more susceptible to price manipulation than small-cap stocks that are traded on major stock indexes. Penny stocks typically relate to companies with a market cap of less than $300 million, while small-cap stocks are often associated with companies that have a market cap of up to $2 billion.
|Penny Stocks||Small-Cap Stocks|
|Traded on OTC markets||Most trade on major stock indexes|
|Not subject to the regulations and scrutiny of the SEC or major stock indexes||If listed on a major stock index, it must file regular financial reports with the SEC|
|Typically cost less than $5 per share and may cost less than $1||May cost more than $5 per share|
|Susceptible to price manipulation through fraudulent activity||Less susceptible to price manipulation, though not completely protected from it|
Companies that list their stocks on OTC markets often do not have to file the same reports with the Securities and Exchange Commission (SEC) that stocks listed on major indexes are required to file. However, many microcap companies do file reports with the SEC that include information about finances, management, and other details.
You may be able to acquire information about microcap stocks from the company itself or from a state securities regulator. The North American Securities Administrators Association can provide information on how to contact your state securities regulator.
Investors who work with a brokerage or investment advisor can ask if a microcap company they are interested in has filed a report with the SEC. You can also conduct your own search on the SEC website or through your online brokerage.
Precautions to Take Before Investing in Penny Stocks
It’s smart to take precautions before investing in any company. With penny stocks, it’s doubly necessary. Before you buy shares, research companies through your brokerage, through the SEC website, through online screening services (a subscription may be required), or elsewhere to find out the following information:
- How the company makes money
- The company’s management and its directors
- Whether trading in the stock has been suspended (available on the SEC listings of stock trading suspensions)
- The background and registration status of any company or advisor that provides unsolicited stock recommendations (using the SEC’s Investment Adviser Public Disclosure (IAPD) database).
A penny stock that is enjoying a sharp increase in price or trading volume for no apparent reason should be a red flag that price manipulation may be occurring.
Every investor at one time or another may hear the tenet “high risks, high rewards.” The more you know about the penny stocks you want to invest in, the more likely you are to experience the rewards side of that equation.
How to Buy Shares of Penny Stocks
If you’re thinking of purchasing penny stocks, in spite of the risks, you can do so through most major online brokerages. Some brokers may place restrictions on these transactions in an attempt to protect investors. Do your research before trading penny stocks to be sure you understand all of the risks involved.
Another thing to consider when investing in penny stocks is how much you’ll pay in broker fees. If the fees you pay are high, it could cancel out the money you make from your penny stock investments. Check out brokers like Charles Schwab or Fidelity for trading penny stocks.
- A penny stock, also known as a microcap stock, refers to a stock that typically trades for less than $5 per share and the company usually has a total market capitalization of less than $300 million.
- Penny stocks typically do not trade on the major stock indexes such as the New York Stock Exchange (NYSE), and instead trade on over-the-counter markets, which can be accessed through websites like OTC Markets.
- The appeal of low-priced penny stocks is the potential for significant increases in value in a short period.
- Significant drops can also occur, which is why penny stocks are considered riskier and more susceptible than other stocks to price manipulation.
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.