Penny Stocks: What They Are & How They Work (2024)

How Penny Stocks Work

Penny stocks generally trade the same as other types of stocks but there are important differences to know. For example, most penny stocks are traded on the over-the-counter market, via the OTC Markets Group, which is far less regulated than the NASDAQ or New York Stock Exchange.

Penny Stocks vs. Other Stocks

Here are the basic differences between penny stocks and other stocks:

• Lower Price: Penny stocks are priced below $5 per share and many are priced below $1. Some penny stocks can even be priced below 1 penny per share.
• Higher Upside Potential: Because of such low pricing, they can have higher upside potential, yet higher risk of losing principal, compared to other stocks, even at those already low prices.
• Mostly Trade on the OTC Market: whereas other stocks primarily trade on the NYSE and NASDAQ. Stocks that trade on the OTC market are on what are called "pink sheet listings" and are commonly referred to as pink sheet stocks or just pink sheets (for short).
• Lower Regulatory Requirements: Penny stocks on the pink sheet listings are not required to meet the same kind of regulatory requirements as the stocks listed on the major exchanges.
• Low Liquidity & Higher Risk of Volatility: Penny stocks tend to have low liquidity because they are typically traded infrequently. This can increase the risk of price volatility, making it difficult for penny stock investors to find pricing that accurately reflects market value. In addition insiders generally retain most of the equity of a penny stock, making them able to dictate price direction.

Tip: Since penny stocks are extremely low-priced, and because they tend to be thinly traded, the prices can be more volatile than conventional stocks. For this reason, investors thinking of buying penny stocks should use caution because the potential for big gains also comes with the potential for steep monetary losses.

Penny Stock Examples

Penny stocks are not well known in the investment community and many of them fail. But there are some penny stock examples that have gone on to become multi-billion dollar enterprises.

Here are a few well-known examples of penny stocks:

• Ford Motor Co (F): In 2008, in the midst of the financial crisis, Ford sold for less than $2 per share, falling into penny stock territory. Today, Ford appears to have returned to moderate strength, although it faces challenges from the electric vehicle market, and the stock trades around $15 per share.
• Monster Beverage Corporation (MNST): In the late 90s and early 2000s, before the energy drink gained in popularity, MNST traded for under 10 cents per share. Today Monster stock trades around $90 per share, as the drink can be found in almost every food market, convenience store, and beverage vending machine.
• Pier 1 Imports: This well-known company was once traded on the NYSE under the symbol PIR but then became a penny stock, a pink sheet listing on the OTC, market under the symbol PIRRQ. The Texas-based home store chain was known for their home furnishings and decor but crushing competition from online retailers like Amazon (AMZN) and Wayfair (W), then the Covid-19 shutdowns in 2020, forced Pier 1 into bankruptcy.

Important: These penny stock examples are for educational purposes and not recommendations to buy any security. Many penny stocks do not go on to become big companies. Penny stocks may also be larger companies that are struggling, or even headed for bankruptcy. For this reason, and because of their speculative nature, penny stocks are not suitable investments for the average investor, who commonly has a long-term time horizon and a moderate tolerance for risk.

Pros & Cons of Penny Stocks

While it is possible to make significant gains with penny stocks, they have unique risks that make them unsuitable for many investors. As is the case with any other investment type, investors are wise to weigh the pros and cons of penny stocks before buying shares.

Pros of Penny Stocks

• Low Price: Since shares of penny stocks are so cheap, an investor can buy a larger position at a lower cost, compared to many conventional stocks.
• Potential for High Return: Penny stocks are commonly small, unestablished companies. Although they are generally associated with high relative market risk, the general attraction to penny stocks is their potential for outsized growth.
• Quick Gains: The wide, short-term swings in price that are characteristic of penny stocks make them a potential target for high short-term returns by swing traders.

Cons of Penny Stocks

• Difficult to Research: Because the penny stocks often represent small, unestablished companies, and because many of them are not required to file reports with the Securities Exchange Commission (SEC), investors may have difficulty assessing the financial health of these penny stocks.
• High Risk/Low Liquidity: Prices for penny stocks can have wide swings, especially in the short term. Low liquidity contributes to this risk because, when there are fewer traders for a given stock, it can be difficult to find buyers, which may expose the stock to substantial downward risk
• Susceptible to Scams: Because they often have less disclosure requirements than other stocks, they may be susceptible to what are called "pump and dump" schemes. This happens when investors buy shares of stock, promote only its attractive qualities, artificially pump up the stock price, then dump the shares to make a profit.

How To Research Penny Stocks

Information about penny stocks can be more difficult to find than conventional stocks. This is because there is often less information for investors to analyze in making a fair assessment of a given penny stock's value. When possible, investors are wise to do their own research, using a few key valuation metrics.

Here are some things to look for when doing your own research on penny stocks:

• Liquidity Ratios: It's important to know if the company you are researching is financially healthy enough to continue operating and pay off its current debt obligations without raising external capital. Liquidity ratios, such as the current ratio, quick ratio, and operating cash ratio, will help with this research.
• Valuation Ratios: The price-to-earnings ratio, or P/E ratio, is the most common valuation ratio but may not be the best for researching penny stocks because their earnings may be close to zero. Other valuation ratios to supplement the P/E ratio include the price-to-sales ratio and the price-to-cash flow ratio.

Where Can You Buy Penny Stocks?

Buying penny stocks can be done in the same traditional way as buying stocks of any other kind. Once you have an account open with a brokerage firm or investment company, and you've funded the account with cash, you may then buy your first shares of penny stocks.

Tip: Not all brokerage firms or investment companies offer the purchase of penny stocks. Investors should use caution in trading penny stocks through a small broker or placing orders over the phone. It's generally best to open a trading account with a large, reputable company, such as Charles Schwab or Fidelity. Because of the unique risks of penny stocks, some brokers will require an investor to formally acknowledge that they understand the risks before buying shares.

How Do You Buy Penny Stocks?

Traditional penny stocks, such as those that trade between 1 penny and 99 cents, are typically traded on the OTC market. Since penny stocks are broadly defined as stocks that trade for less than $5 per share, some penny stocks can be traded on a major stock exchange, such as the NYSE or NASDAQ.

As an individual investor, you won't place trades directly on a major exchange or OTC market. You'll need to open a trading account with a brokerage firm or investment company to buy shares. Ideally, you will find a brokerage firm that enables you to trade penny stocks on the same platform as you would any other stock.

Important: Just because penny stocks are low-priced does not mean that they are low-risk investments. For example, let's say you buy $1,000 worth of shares in a stock that trades for 4 cents and the stock falls in price by 2 cents per share. A stock price decline of $0.02 might seem small, but in this case it would mean that the principal amount you invested fell 50 percent, for a loss of $500!

Kent Thune