What are penny stocks? (2024)

Key points

• Penny stocks are among the cheapest and most volatile investments in the stock market.
• Penny stocks can generate extreme short-term gains, but most are bad long-term investments.
• Limited financial disclosure requirements and lack of regulatory oversight create opportunities for scams and deception.

Penny stocks are among the most volatile and exciting investments in the stock market. However, they are also notoriously bad long-term investments. Any investor considering buying penny stocks should fully understand the basics of how they are traded and the risks involved.

What are penny stocks?

Penny stocks are generally stocks that trade for less than $5 per share. Some investors see penny stocks as attractive speculative investments because their low share prices allow investors to buy a large number of shares for a small amount of money.

Plenty of penny stocks trade on major U.S. exchanges, including the New York Stock Exchange (NYSE) and Nasdaq. However, the majority of penny stocks trade via over-the-counter (OTC) transactions or on the electronic OTC Bulletin Board system.

OTC-traded stocks generally have fewer listing requirements, lower financial standards and minimal regulatory disclosure rules compared to stocks that trade on major exchanges. The lowest tier of OTC-traded stocks that trade on the Pink Open Market don’t have any financial standards or disclosure requirements, leaving investors particularly susceptible to deception and scams.

Pros and cons of buying penny stocks

Penny stocks are among the most popular speculative investments in the stock market and are well known for their extreme volatility. They can be a double-edged sword of extremely high risk and extremely high upside.

Pros

• Low cost. There are plenty of penny stocks that trade for 10 cents per share or less, making it easy for investors to buy thousands of shares for as little as $100. Low share prices can be particularly attractive to investors with limited capital.

• Tremendous upside potential. Penny stocks can have tremendous upside potential relative to large-cap S&P 500 stocks. There are many examples of penny stocks trading for 10 cents or less that have returns of 1,000% or more over the short or medium term, and they may not even rise above $1 per share.

• Potential for overnight success. Because of the extreme volatility among penny stocks, some traders are lured in by the potential to get rich quickly. On any given day, there may be dozens of penny stocks that gain more than 100% or even 1,000%, but those gains often do not last long.

Cons

• Unpredictable price movements. The limited liquidity among penny stocks means a relatively low volume can trigger extreme swings in stock prices, making penny stocks particularly unpredictable. Penny stocks also often move more on rumors, momentum and market psychology than on fundamental company performance metrics, making them difficult to analyze and value.

• Limited information. OTC-traded penny stocks, particularly those that trade on the Pink Open Market, are not subject to the same rigorous financial disclosure and accounting standards as stocks that trade on major exchanges like the NYSE and Nasdaq. As a result, investors may be left with unreliable, incomplete or no information on the underlying business performance of penny stocks.

• Prone to scams. Limited disclosure requirements and lack of regulatory oversight make “penny stock land” like the Wild West of investing. The combination of limited liquidity, inexperienced investors and virtually no regulatory oversight creates a perfect opportunity for penny stock scammers.

Asher Rogovy, chief investment officer of the investment advisory firm Magnifina, says legitimate companies seek legitimate sources of financing and avoid selling shares of stock for under $5.

“If a company has a good chance at profitability, they could use a number of private channels for financing without needing to issue penny shares,” Rogovy says.

There are many scams among penny stock companies that trade over the counter, and the U.S. Securities and Exchange Commission (SEC) has issued warnings about investing in penny stocks. The SEC says investors who buy penny stocks “should be prepared for the possibility that they may lose their whole investment.”

Rogovy says investors shouldn’t count on regulators like the SEC to protect them from penny stock scams.

The SEC “knows fraud is common, but the costs of prosecuting it are higher than the proceeds of the scam,” he says.

Best practices if you decide to buy penny stocks

Investors who understand the risks of penny stocks and still want to try their hand at penny stock trading should rely on primary sources of information, such as SEC filings and company press releases, rather than third-party postings on message boards or social media. Penny stock traders can also get a feel for how penny stock trading works by using a free stock trading simulator before they put their real money at risk.

Yet Robert Johnson, a chartered financial analyst and finance professor at Creighton University’s Heider College of Business, says the best way to trade penny stocks is to not do it at all.

“For the vast majority of investors, investing in penny stocks is wholly unsuitable and ranks right up there with speculating in crypto as a dumb idea,” Johnson says.

Given the rampant fraud among penny stocks, he says penny stock investors are playing with fire.

“Investors should simply expect to lose their investment in penny stocks,” Johnson says.

Safer alternatives to penny stocks

For investors who want to make big gains in the stock market but are concerned about the risks of penny stock trading, there are safer alternative investment strategies. Here are a few examples.

Exchange-traded funds

Derek Miser, investment advisor and CEO at Miser Wealth Partners, says exchange-traded funds (ETFs) offer an excellent source of long-term investment upside that reduces risk through the power of diversification. ETFs hold baskets of dozens or even thousands of stocks, limiting the risk associated with any individual stock. For example, SPDR S&P 500 ETF Trust (SPY) is one of the most popular ETFs in the market. It holds shares of all 500 companies in the S&P 500 index, including Apple (AAPL), Microsoft (MSFT) and Alphabet (GOOG, GOOGL).

Blue-chip stocks

For investors looking to take a chance on individual stocks in a responsible way, Miser says investing in blue-chip stocks is a better approach than buying penny stocks.

“Blue-chip stocks are stocks of large, well-established companies with a history of stable earnings and dividend payments. While they may not offer the same level of growth potential as penny stocks, they are generally considered less risky and more stable,” Miser says.

Many brokers allow investors to buy fractional shares of blue-chip stocks, so even investors with a limited initial investment budget can construct a personalized portfolio of higher-priced blue-chip stocks.

Real estate

Investing in real estate can be an excellent source of income and long-term capital appreciation, Miser says. Examples include buying rental properties or investing in real estate investment trusts.

Frequently asked questions (FAQs)