Penny Stocks: Definition, Risks & How They Work

A penny stock is a common share of a small public companyPrivate vs Public CompanyThe main difference between a private vs public company is that the shares of a public company are traded on a stock exchange, while a private company's shares are not. that is traded at a low price. The specific definitions of penny stocks may vary among countries. For example, in the United States, the stocks that are traded at a price less than $5 are considered penny stocks, while in the United Kingdom, penny stocks are only the stocks that are priced below £1.

Penny stocks are usually classified as microcap stocks with a market capitalizationMarket CapitalizationMarket Capitalization (Market Cap) is the most recent market value of a company’s outstanding shares. Market Cap is equal to the current share price multiplied by the number of shares outstanding. The investing community often uses the market capitalization value to rank companies of less than $250 million or $300 million.

The majority are traded over-the-counterOver-the-Counter (OTC)Over-the-counter (OTC) is the trading of securities between two counter-parties executed outside of formal exchanges and without the supervision of an exchange regulator. OTC trading is done in over-the-counter markets (a decentralized place with no physical location), through dealer networks.. However, some may be traded on the big stock exchanges such as NASDAQ or the New York Stock Exchange.

U.S. SEC Definition of Penny Stocks

The U.S. Securities and Exchange Commission (SEC) provides its own specific definition of a penny stock. The SEC determines the following features of the stocks:

• Shares issued by a small company that are traded at a price below $5 per share. These stocks can also include the shares of certain private companies with no active trading market.
• Shares are usually traded over-the-counter such as on the OTC Bulletin Board or OTC Link LLC but can also be traded on the securities exchanges, including foreign securities exchanges.
• The shares are extremely illiquid.
• It can be difficult to price the stocks since price quotations for the shares cannot be easily obtained.

Penny Stocks as Investments

Similar to other types of shares, penny stocks can be used as an investment vehicle. However, a potential investor must be careful with such investments. The stocks are inherently speculative due to their high volatility and low liquidity.

In addition, these stocks are frequently used in fraudulent activities. For example, they are subject to pump and dump schemes, where their prices are manipulated by the stock promoters.

A potential investor must be aware of the following characteristics that make them extremely risky investments:

1. Low liquidity

Since many of the penny stocks are traded over-the-counter, the liquidity of the stocks is low. An investor may not always be able to sell the shares at the right time. Also, the low liquidity results in low trading volumes. Thus, even relatively small transactions can cause large swings in the price of the shares.

2. Limited historical information

Most of the stocks of relatively young companies with limited historical information. The companies generally lack a proven track record regarding operations, products, assets, or revenues. Therefore, investing in such companies is extremely risky.

3. Lack of public information

The microcap companies that issue penny stocks are not required to file reports with the regulatory authorities (e.g., SEC). In addition, these stocks are not covered by professional stock analysts from designated financial institutionsKey Players in the Capital MarketsIn this article, we provide a general overview of the key players and their respective roles in the capital markets. The capital markets consist of two types of markets: primary and secondary. This guide will provide an overview of all the major companies and careers across the capital markets.. Therefore, potential investors may not find sufficient resources to make an informed investment decision.

4. No minimum listing requirements

Since penny stocks are primarily traded over-the-counter, the companies that issue these stocks are not required to meet certain minimum requirements for the listing.

More Resources

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To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

• Investing: A Beginner’s GuideInvesting: A Beginner's GuideCFI's Investing for Beginners guide will teach you the basics of investing and how to get started. Learn about different strategies and techniques for trading
• Long and Short PositionsLong and Short PositionsIn investing, long and short positions represent directional bets by investors that a security will either go up (when long) or down (when short). In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long), or sell it (going short).
• Primary MarketPrimary MarketThe primary market is the financial market where new securities are issued and become available for trading by individuals and institutions. The trading activities of the capital markets are separated into the primary market and secondary market.
• TickerTickerA Ticker is a symbol, a unique combination of letters and numbers that represent a particular stock or security listed on an exchange. The ticker symbol is used to refer to a specific stock, particularly during trading. Trades are executed based on a company's ticker symbols