What is a Penny Stock? What You Need to Know About Penny Stocks

So, you want to learn how to buy penny stocks? You might need to bring some Dramamine if you struggle to tolerate volatility — trading penny stocks can take you on a rollercoaster ride. 

What are penny stocks?

Penny stocks are companies with very low market caps and limited share floats, often trading off the major exchanges. They're volatile, vague and often the target of fraudsters and phony stock gurus. But volatility is tempting, and correctly timing your penny stock trades can lead to quick riches. 

What Are Penny Stocks?

What is a penny stock? You might get a different answer depending on who you ask, but penny stocks aren't always stocks trading for pennies. The limit for most true "penny stocks" is $5 per share, giving many access to major exchanges like the New York Stock Exchange or NASDAQ Exchange.

Many penny stocks do not meet the requirements for listing on the NYSE or NASDAQ, so they're forced to trade "over the counter." OTC stocks aren't always penny stocks. Some large international firms using American depositary receipts (ADRs), like Tencent Holdings Ltd. OTC: TCEHY and the Nintendo Company Ltd. OTC: NTDOY, trade on these secondary markets. 

OTC markets are the Wild West of stocks — companies are not subject to the same rules and regulations as those operating on the major exchanges and information about them can be scarce. If you recall the movie "The Wolf of Wall Street," con man Jordan Belfort used OTC stocks (notably pink sheets stocks) to scam his unsuspecting "clients."

Overview of Penny Stocks

If you want to learn how to buy penny stocks, you'll first need to understand why they're considered penny stocks in the first place. All companies need to start somewhere when beginning to trade on public markets, but most companies that go to IPO don't start as penny stocks. Generally, underwriters prefer an IPO price over $10, even special purpose acquisition companies (SPACs), which exist solely to merge with a private company and avoid the traditional IPO process.

The truth is that most penny stocks are companies that carry a hefty load of baggage. They may be drug makers with a minimal track record of success, have questionable accounting practices, or be outright shell companies. No company sets out to be a microcap penny stock, but missteps can cause these firms to drop off the major exchanges.

A few different levels of penny stocks exist. First, shares under $5 that still trade on major exchanges have the best odds of success. These shares are more liquid with lower spreads and abide by the NYSE or NASDAQ's stringent reporting requirements. If a company trades on a major exchange, you'll be able to find plenty of publicly available information about its balance sheet and earnings statements.

Next comes the stocks in the OTC Market Group's OTCQX and OTCQB tiers. These companies don't trade on major exchanges but are subject to some reporting requirements. For example, stocks in the OTCQX tier must submit regulatory disclosures and audited financial statements and cannot be in bankruptcy. 

Finally, there are the dregs of the market — the pink sheet stocks. Financial information about these companies is virtually nonexistent, and they often have a share price below a penny. Regulation of these firms is usually light, and their low share float and minimal market cap make them a prime target for pump-and-dump schemes. 

Penny Stock Volatility

Volatility is the name of the game when trading penny stocks. Since it's incredibly cheap to acquire shares and volume on these stocks tends to be low, volatility can be extreme. Penny stocks often make risky assets like cryptocurrencies look stable.

For example, take Bright Health Group Inc. NYSE: BHG, one of the largest penny stocks with a market cap of over $500 million. Despite its size, which dwarfs most other penny stocks, BHG is no stranger to 50% upswings and declines. For penny stocks with micro market caps, 100% moves in a single day aren't uncommon. 

Pros and Cons of Penny Stocks

Like any tradable security, penny stocks carry pros and cons. However, trading penny stocks is one of the riskiest maneuvers in markets, so keep this list in mind when deciding on penny stocks to buy.

Pros

First, let's walk through the benefits of penny stocks: 

• Cheap investment: Buying a significant stake in a penny stock will likely become a manageable capital commitment.
• Potential for exponential returns: People don't invest in penny stocks because they believe in the company's mission or have faith in the executives. Nope, it's usually pure speculation due to the ability to make exponential returns if they time the trade correctly. The idea of 100% daily returns is often too irresistible for traders to avoid. 
• Little competition for shares: Penny stocks usually have a low float of available shares, but only some traders dive into these waters, so the competition for them is rarely strenuous.

Cons

Now, the downsides of penny stocks: 

• Volatile: Depending on your mindset, this may be something other than a con. But penny stocks are very volatile and usually unsuitable for long-term investment. These stocks are day or swing trades, not buy-and-hold portfolio pillars.
• Ripe for manipulation: What do you get when you combine a low float, low market cap stock, a lack of financial documentation and the potential for significant returns? You get pump-and-dump schemes! The SEC recently charged eight stock market "influencers" with fraud for allegedly pumping and dumping penny stocks on their social media followers.
• Counterparty difficulty: Even if you score a considerable return from a penny stock, you may have problems exiting the position smoothly. Every seller needs a buyer, and with thinly-traded penny stocks, buyers are frequently in short supply. Position sizing is a crucial concept to understand when trading these types of stocks.
• Little information for due diligence: Stocks listed on major exchanges must disclose certain financial information, OTC and pink sheet stocks have different standards. Finding accurate financial data on penny stocks can be a frustrating exercise.

Tips for Investing in Penny Stocks

Even the best penny stocks carry a decent amount of risk. If you want to increase your success rate when trading penny stocks, check out some advice to consider.

Use a Broker with Access to Penny Stock Shares

Only some brokers can locate certain penny stock shares, so make sure the stocks you want to trade are available if you still need to choose one. Additionally, many brokers have different transaction fees for OTC stocks versus exchange-listed stocks, so make sure you understand the fee structure before executing any trades.

Keep Position Size Small 

There are two reasons to limit position sizes when trading penny stocks: first, you don't want to risk too much capital on any single stock (let alone a penny stock) and second, you want to make sure you can sell all your shares when it comes time to close the trade.

Plan Your Entry and Exit Points 

The odds of you finding the next Amazon or Microsoft down with the penny stocks is exceedingly low. These companies aren't usually suitable for long-term investing but can be profitable trades with proper planning. Make sure to have profit targets and know when to cut losses if trades don't go your way.

Be Nimble 

Trading penny stocks isn't for the faint of heart. You'll need to stomach some severe volatility, know when to take profits and move on. Unlike long-term investments, you should monitor penny stocks so you can open or close positions quickly.

How to Make Money on Penny Stocks

You can make money on penny stocks, but you must have a system of rules and follow it dispassionately. If you don't have the temperament for highly volatile stocks, you should turn to a more traditional type of investing.

You'll want to develop some guidelines to make money trading penny stocks. Here are a few ideas to get started:

1. Never invest more in penny stocks than you can afford to lose.
2. Understand technical analysis concepts like support and resistance.
3. Be prepared to enter and exit positions in short time frames, sometimes in just a matter of minutes.
4. Cut losers quickly.
5. Sell winners once you reach your profit goals.
6. Stay away from easily manipulated stocks like pink sheets or shares with no volume.

Signs of Penny Stock Scams

A common penny stock scam will play out like this: a supposed stock-picking "expert" with a large social media following will scoop up cheap shares of a low-float, low-volume penny stock. Once they establish this position, the scammer will concoct a story about an upcoming catalyst like an acquisition or positive results from a drug trial. 

The scammer will then alert their social media followers about this great "opportunity" and unload their position as the followers pile into the stock and push the price higher. Inevitably, the story dies, and the followers lose money while the scammer moves on to a new stock.

Not all social media stock pickers are scammers, but the easiest way to pull off this trick is to use inexperienced followers as exit liquidity in lightly traded securities. Be cautious of any anonymous social media personality that offers stock-picking advice. If you want to join a Discord group or stock trading chat room, ensure the people running it are transparent about their decisions and thought processes.

Understanding Penny Stock Regulations

Penny stocks that trade over the counter are subject to different reporting requirements than those on major exchanges. The SEC does have some specific legislation in place to protect unsophisticated investors from the risks of penny stocks.

For example, OTC stocks trade through a broker-dealer network, not an exchange, so prices can be delayed or inaccurate. SEC guidelines require any salesperson to accurately quote the bid and ask prices of the shares and make public any compensation they receive from facilitating a penny stock trade. 

Brokers must also provide timely account statements to penny stock investors and disclosures about the risks of trading penny stocks. Broker-dealers cannot sell penny stocks to investors without determining whether such an investment would suit the individual investor. For more on penny stock-specific regulation, see the Penny Stock Reform Act of 1990.

Penny Stock Risks Often Outweigh the Rewards

Trading penny stocks can seem tantalizing to investors with high risk tolerances because the potential returns are astronomical. But these stocks are often on shaky financial ground and don't have a track record of success. 

Remember, you won't find the next Amazon trading over the counter. However, if you have a firm grasp of technical analysis and a sharp nose for detecting fraud and scams, you can make money trading penny stocks. But be prepared to tolerate the uncertainty of trading companies with questionable backgrounds.

FAQs

Traders new to the world of penny stocks often have many questions. Here are a few commonly asked questions about which penny stocks to buy now.

What are examples of penny stocks?

Penny stocks are companies with a share price below $5, many of which trade off the major exchanges like NYSE or NASDAQ. They're often low-market cap biotech companies such as AquaBounty Technologies Inc. NASDAQ: AQB or Rubius Therapeutics Inc. NASDAQ: RUBY or tech firms like HyreCar Inc. NASDAQ: HYRE or Rockley Photonics Holdings Limited NYSE: RKLY.

Where do you buy penny stocks?

Not all brokers will have access to penny stock shares since many of them trade OTC or on the pink sheets. If you're looking to trade penny stocks, select a broker that can provide these shares. Sometimes even the best penny stocks can be challenging to track down with traditional brokers.

Are penny stocks a good investment?

Penny stocks are often good trades but rarely work out as long-term investments. Most of these companies are thinly traded for a reason and are often ripe for scammers. Penny stocks have a high failure rate, so be sure to research well and have a plan for entry and exit.

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