What Are Penny Stocks (and Why Are They Called That)?
Penny stocks are the stocks of small, public companies with low prices and low trading volume, most of which trade on over-the-counter (OTC) markets instead of on major exchanges like the NYSE or the Nasdaq.
According to the SEC, penny stocks are those that trade for less than $5 per share, although the term used to refer only to stocks that traded below $1 per share, hence the reference to pennies.
Because of their low trading volume and relative obscurity, penny stocks are characterized by high bid-ask spreads. Unlike more popular stocks that trade constantly on major exchanges, penny stocks have few buyers and sellers, so trades can take a very long time to execute. Additionally, because penny stocks usually have a relatively small number of shares, they are notoriously volatile—individual trades, especially of many shares at once, can cause significant price swings.
All of these factors make penny stocks very risky compared to traditional equities.
Where Are Penny Stocks Traded?
While plenty of stocks with share prices under $5 trade on the major exchanges, most “true” penny stocks trade over the counter via OTC Markets Group (stocks that trade here used to be known colloquially as “pink sheets”).
Formerly, many penny stocks traded on the OTC Bulletin Board (a stock quotation service provided by FINRA), but the service was discontinued on November 8, 2021.
Characteristics of the Penny Stock Market
- Low stock prices
- Low market capitalization
- Low liquidity
- High volatility
- Wide bid-ask spreads
How Risky Are Penny Stocks?
Penny stocks are much riskier than traditional equities for a variety of reasons. Their market is relatively illiquid, so it can be difficult for sellers who want to cash out their shares to find buyers in a timely manner. And, since penny stock prices are volatile, this lack of liquidity can result in shares losing significant value between when a sell order is placed and when it is eventually filled.
Penny stocks are attractive to speculators because they are cheap and therefore have the potential to increase significantly in value. For this reason, penny stock promoters have been known to aggressively market shares to vulnerable consumers via telephone and internet “pump and dump” schemes.
These promoters buy shares of dubious companies (sometimes companies created for the sole purpose of securities fraud) for cheap, then promote them deceptively to drive share prices up before liquidating their own shares for a profit, devaluing everyone else’s shares in the process.
Should You Invest In Penny Stocks?
For the average, passive investor, penny stocks are probably more trouble than they’re worth. While they do have significant upside potential, they are risky and subject to far less regulation than stocks that trade on major exchanges. Additionally, many are close to bankruptcy, and some may be entirely fraudulent.
That being said, many major, successful companies that now trade in large volumes on major exchanges began their journeys as penny stocks. Prudent and active investors who aren’t afraid to spend significant time reading financial statements and learning about a company’s history, management, and plans may be able to identify legitimate companies that currently trade as penny stocks but may have a bright future ahead of them.
Major Companies That Began as Penny Stocks
- Ford Motor Company (NYSE: F)
- Apple Inc. (NASDAQ: AAPL)
- Amazon (Nasdaq: AMZN)
- Advanced Micro Devices (Nasdaq: AMD)
- Plug Power (Nasdaq: PLUG)
- GameStop (NYSE: GME)
- AMC Entertainment Holdings Inc. (NYSE: AMC)
