What Is A Penny Stock? | A Complete Guide

Investing
Updated: 25th Feb 2021
Written by Ryan Barnes
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Penny stocks endure wild swings and are a risky play for investors. Apple, Google, Amazon, Facebook, Microsoft – dominate stock market portfolios. However, sometimes these are too expensive to own for investors.

Read on to find out what penny stocks are, why they’re seeing a surge in popularity, and how to approach trading penny stocks.

What is a Penny Stock?

A penny stock is the investor’s nickname for low-priced shares of a (typically) small company. Penny stock shares are not listed or traded on a stock exchange like the Nasdaq or the New York Stock Exchange.

The U.S. Securities and Exchange Commission (SEC) defines a “penny stock” as any shares trading for under $5/share on an over-the-counter exchange or listing service.

Over-the-counter (OTC) is a catch-all for any method of share trading outside of the traditional exchanges.

The most popular OTC exchanges are managed by the OTC Markets Group (formerly named Pink Sheets), which provides daily quotes and trading availability for over 10,000 penny stocks.

While OTC Markets Group (and other OTC providers) employ a classification and rankings system to showcase transparent companies, all penny stocks have vastly lower regulatory and disclosure hurdles than a stock trading on a stock exchange.

For example, to be listed on the NYSE, companies must have a value (market capitalization) of at least $100 million and over 1.25 million publicly traded shares trading for at least $4/share.

There are also annual listing fees and mandatory SEC filings every financial quarter with audited results.

Stocks that are traded over the counter have very few listing requirements and less strict SEC reporting guidelines.

As such, penny stocks are less regulated, less traded, and are far more volatile than the average stock listed on a major exchange.

Understanding Penny Stocks: What You Need to Know

Now that we’ve got the boilerplate definition out of the way, here’s what investors curious about trading penny stocks need to know in 2021.

Penny stocks may also be referred to as micro-cap stocks, pink sheet stocks, or just small-cap stocks, depending on who’s describing it.

More than anything, the “penny stock” moniker implies a cheap stock that is thinly traded (not much trading volume day-to-day), a stock that will have a volatile price, and a stock that is going to be hard to find accurate, up-to-date information on.

This ambiguity is what makes trading penny stocks a risky endeavor even for experienced investors.

In contrast, it’s quite easy to look up every SEC filing and sort through any piece of financial information about a company that is listed on the NYSE or Nasdaq.

There is an inherent level of respect for a company that trades on a major stock exchange and an implied sense of transparency.

Public companies that lie or report false information pay dearly. The SEC does not mess around.

Meanwhile, there is an inherent level of skepticism for any OTC stock/penny stock and an implied sense of uncertainty.

Penny stocks can lend themselves to scams, promotion blitzes with no real products behind them, and other sorts of shenanigans – all due to being “unnoticed” by regulators and large institutional investors.

There are two main reasons a company’s stock ever lands on the OTC:

#1. They used to be listed on a stock exchange but got delisted because of a failure to meet the requirements, such as:

  • A minimum amount of revenue,
  • Regular (quarterly) reporting of audited results, or
  • Minimum share price requirements.

#2. They are a company with no “real” products, low sales growth (if any sales at all), and cannot meet the minimum requirements for a stock exchange.

And if we were to rank a 3rd reason, it’s that a shady CEO is selling shares of a worthless shell company that has no hope of ever succeeding.

In any of these three cases, is the stock worth owning? Probably not.

Penny Stocks Meet Social Mania in 2021

This doesn’t mean that all penny stocks are untouchable. Even penny stocks that end up turning to dust may have spurts of rising prices, and occasionally an uncut gem can be found in a penny stock.

To start off 2021, penny stock investors have seen some of the wildest price swings in decades, thanks to a spike in retail day trading and a massive increase in social media platforms, such as Reddit’s popular WallStBets forum.

Some penny stocks have risen 200%, 400%, even 2000% or more in a matter of days.

In some cases, there was no actual penny stock news involved at all, just a bunch of people chatting in an online forum.

In other cases, even being mistaken for another company altogether was worthy of a 20-30x spike in price!

Consider the curious case of Signal Advance Inc, a penny stock that trades OTC. In early January, Signal Advance Inc sat at $0.60/share. This equity has not seen a price north of 2 bucks in over 5 years.

On January 7th, Elon Musk sent a short but somewhat nebulous two-word tweet, “Use Signal”.

Musk was tweeting in response to a new Whatsapp (owned by Facebook) privacy policy that had users spooked and looking for alternatives to the ghost messaging provider.

Signal messenger is part of an open-source project that is a private entity and has no stock to trade.

But that did not stop some slapstick lunacy from happening anyway. Enter Signal Advance Inc, a company with one employee, no products or sales, and most certainly having nothing to do with the Signal messaging app.

Signal Advance Inc and its ticker SIGL started getting bids – lots of bids. Considering there are days where this stock has no shares traded, this movement is almost unprecedented.

SIGL went 60 cents per share to over 40 bucks in less than three days, at one point gaining over 11,000% (no, that is not a misprint).

Unsurprisingly, the lone employee of “Signal Advance” did not put out a press release to remind investors that his company has nothing to do with the Signal app and to please stop buying the stock on wrong information.

And while Signal Advance has given up almost all of its early gains, it is still sitting there with a several-hundred-percent gain on absolutely zero news (and still no products or sales).

Trading Penny Stocks

Penny stocks can get spicy at times, making massive moves after sitting languid for months on end.

It is quite easy for just one or two day traders to move a penny stock, as shares can be dirt cheap, and tens of thousands can be scooped up for a couple hundred bucks.

Newcomers to stock investing can easily get sucked into the allure of penny stocks, making large moves.

And those “one or two relatively small day traders” know this, manipulating penny stocks for a few days, catching a quick rip as others follow the initial move they caused, before quickly dumping their shares and moving on to the next target.

The SEC has had its hands full for prosecuting scores of cases just like this.

Very few “penny stock success stories” exist, where a micro-cap stock went from an OTC listing to an upscale major stock market listing, going on to be worth tens of billions.

The success rate is less than 1/10,000. The vast majority just fritter away in the $0.10- $1.50/share zone for years on end, never making any noise as the underlying company slowly dies off or fades away.

An investor who buys a penny stock when it is hot may see a lot of trading volume initially, then in a couple of weeks, there is hardly anyone trading it all.

This can make it difficult to get a good price to sell shares. This illiquidity is one of the reasons investors do not like trading penny stocks – the price you see on a quote may be far from the price you can get, and this applies when the stock is going up and when it’s going down.

Because of the inherently high risk and illiquidity of penny stocks, some brokers and newer app-based trading platforms don’t even offer access to OTC/penny stock trades.

Robinhood is an example of this; no OTC stocks are available to trade. The investor fervor over Gamestop shares in 2021 – and Robinhood’s reaction to limit trading in it and other penny stocks – led all the way to hearings in the U.S. Capitol.

Best Brokers for Penny Stocks in 2021

Because some trading apps like Robinhood and Public have restrictions or limitations on over-the-counter stock trading, investors that are looking to buy and sell penny stocks should consider the largest, most-established brokerages like Charles Schwab or Fidelity.

These brokers have a wide array of available securities to trade on their platform, as they are broad financial services institutions that seek to provide customers “one-stop-shop.”

It’s important to note that just having the availability to trade penny stocks on a platform like Schwab, Fidelity, or Merrill Edge does not mean that penny stocks become safer.

All the risks of buying a penny stock remain, no matter what brokerage you use to make the trade.

No broker will compensate you for losses on your penny stocks should you get into a bad trade and see the price go down rapidly.

Learn More: How to Start Investing

Best Trading Tools for Penny Stocks

Because there is not much accurate, up-to-date information to be found on penny stocks, and because there are just so, so many of them, the most popular way to hunt for trading opportunities is through what’s called technical analysis.

Put simply, technical analysis is when an investor uses charts and historical prices to find stocks that are moving in desired patterns and showing good trading volume (investor interest).

Stock screens are also popular for hunting through thousands of ticker symbols. Investors can set filters for things like rising prices, high trading volume, and stocks following a specific technical pattern.

There is no guarantee that a penny stock moving higher is a smart trade but having some pre-set rules about when to consider a trade or not is a technique used by almost all successful investors.

Learn More: Best Stock Market Research Websites

How to Research Penny Stocks (Step-by-Step)

  1. Use a stock screener or filter to select penny stocks that meet the requirements you set. Popular filtering/screening items are things like:
    1. A rising stock price over the past month/quarter/year; rising moving averages of 50 or 200 days
    2. Above-average trading volume over the recent past
    3. Stocks that were up in a down market period
    4. Stocks that have recently tested support or resistance levels and “bounced off of them.”
  2. Once you have a narrowed down list of 15-25 names, give or take, you can start reading about the individual company by searching Google for press releases and/or an investor relations section on their homepage.
  3. Search the ticker on a social media platform to see what kind of investor interest is in the stock. There are also free directories that list press releases from every company that issues anything (assuming they hired a mainstream PR firm to handle the release). Penny stock news in the form of press releases are usually advertisements – not factually validated materials. So, proceed with caution. But to learn about what the company does, a press release could add some insight.
  4. Look at charting patterns to find a specific target price to buy or sell. Having price triggers in place takes a lot of the emotion out of the process, bringing good discipline to your investing plan.

Learn More: How to Research Stocks

Are Penny Stocks Safe?

Penny stocks, despite their low price per share, are riskier than mainstream stocks of larger companies.

Ten times out of ten, if you invested $1000 into a penny stock vs investing $1000 into a stock on the Nasdaq, the penny stock is going to be riskier.

Historical data validates that penny stocks not only move up and down more rapidly than other stocks, but they also fail (go bankrupt) at a higher rate.

Remember, most penny stocks got to where they were for a reason. They aimed higher and ended up where they are, off-Broadway.

That says a lot about the underlying business.

Learn More: Best Financial Magazines

Bottom Line: What Are Penny Stocks?

Penny stocks are shares of a stock that trade for under $5, and in most cases, under $1. They are not traded on major stock exchanges but instead trade over-the-counter.

Their increased level of risk and lack of transparent financial records makes them unsuitable for risk-averse investors. They can be traded effectively with a deft hand and a rules-based approach.

Some brokers and trading apps don’t offer penny stocks, so check with your broker before diving into penny stock research or news.

The largest brokerages offer access to penny stocks, so investors looking to get in on the penny stock lifestyle will want to migrate to a large-scale online brokerage.

More Investing Resources:

Ryan Barnes
Ryan Barnes
Ryan is a certified Chartered Financial Analyst (CFA) with over 15 years of experience managing and steering hundreds of millions in client assets through complex and dynamic financial markets. Ryan’s work has appeared in the Wall Street Journal, Barron’s, Forbes, Nasdaq.com, Investopedia, and Bloomberg. Additionally, he has multiple citations in peer-reviewed papers for reporting done on the U.S. housing market preceding the Great Financial Crisis.