What Is a Penny Stock? An Investment Most Should Avoid

Investing, Investments
What Is a Penny Stock?

Penny stocks sound great in theory: They are inexpensive and have unlimited upside potential. That’s why they draw in investors, particularly those just starting out or looking to make a quick and cheap buck.

But as with most things, when an investment sounds too good to be true, it probably is. It’s easy to see why penny stocks are inexpensive when you look closer at what you’re actually buying.

What is a penny stock?

Despite their name, penny stocks — also called microcap stocks — don’t actually cost a penny per share. Just as not everything in a dollar store is really $1, penny stocks generally are defined as stocks that trade for less than $5 a share. That definition may vary by broker; some put the cap lower, at $3 or $2 a share.

In either case, this is not your typical adventure in buying stocks. Penny stocks trade for that little not because you’re getting in on a good deal but because the companies issuing penny stocks are small and often volatile — in some cases, they might even be heading toward bankruptcy.

These companies are typically too small to be quoted on the major stock exchanges. In some cases, they’ve been delisted — pushed off an exchange — for not meeting requirements or maintaining a high enough share price.

Instead, penny stocks are traded over-the-counter, through quotation systems like the OTC Bulletin Board or OTC Link LLC. They can still be traded through many online brokers, though some impose an additional charge or account minimum on penny stock trades.

When you trade penny stocks, you’re betting that one of these small companies has what it takes to go big. That’s rarely the case. Here’s why.

It’s a market rife with scams

Google “penny stock scams” and you’ll find no shortage of results. Even the websites that tout penny stock trading as a viable investment strategy admit that scams run rampant.

The Financial Industry Regulatory Authority and the Securities and Exchange Commission have issued warnings about penny stocks, specifically about “pump and dump” schemes. In such schemes, scammers buy shares of what FINRA has referred to as “dormant shell companies with little to no business operations” and then promote the stock as the next hot buy. When the price rises, they sell their shares, causing prices to plummet. Remaining investors are left with what is in many cases a worthless security.

These days, the promotion may come via email or as a voicemail. Scammers frequently pretend they’re leaving a message with a stock tip for a friend; it appears to be a wrong number, but the mention of the next big winner piques your interest. This goes for any stock, not just penny stocks: If someone tells you a stock is hot, consider the source and do your own research.

Penny stocks are hard to vet

Public companies are required to file regular reports with the SEC, baring the status of their business via audited financial statements. They’re also required to meet minimum standards to be listed on major exchanges, often including a floor for earnings, number of shareholders and the market value of those shares, among other things. (Interested in a little light reading? Scroll through the Nasdaq listing standards.) And then there is intense scrutiny from stock analysts and researchers, who quickly bring any blemishes in the business into the light of day.

Companies issuing penny stocks may not have to file with the SEC if they hold less than $10 million in assets or have fewer than 2,000 shareholders of record. They are unlikely to be covered by analysts, and while some OTC marketplaces have minimum listing requirements, others don’t. All of this can make penny stock issuers very difficult to research and accurately price.

Penny stocks can be hard to sell

Given the above, this point now veers toward self-explanatory. Who would want these things? But if you still do, consider this: You don’t make any money on an investment until you sell that investment and realize a gain on the sale. If you buy a stock for $2 and the share price shoots up to $100 — an unlikely short-term scenario anyway — that $98 is no more than a paper gain until you sell the stock and pocket the proceeds.

Penny stocks bring together the dangerous combination of low liquidity and high volatility. They’re often hard to unload, due to all of the above and because the market for these securities is smaller. At the same time, they can be subject to wild and rapid price swings, which means the price could shift dramatically before you find a buyer.

An alternative to consider

If the low price is the main attraction here, you should know there are other investments that are similarly low-cost but come with far less baggage. We’d steer you toward exchange-traded funds.

ETFs track an index, like the Standard & Poor’s 500, and hold shares from the companies in that index. These funds trade like a stock, on an exchange, for a share price, which can be much lower than the typical index fund or mutual fund minimum.

That means you can get instant diversification for a small investment. Depending on the ETF, you could buy in for as little as $20 or $30 a share. Like stocks, though, some ETFs are priced much higher. That’s more than a single share of a penny stock, sure. But here you’ll get a stake in a basket of listed, regulated companies.

You can also find ETFs at many brokers commission-free, which will save you on the transaction costs that come from a penny stock trade.

» View our picks: The best brokers for ETFs

If you must buy, buy cautiously

If you still feel called to penny stocks, at least follow a few rules that can help curb risk:

  • Stick with companies that are registered with and regularly report to the SEC
  • Research the company and its key officers before you purchase. (Here’s how to research a stock.) Understand the industry, how the company makes money and its chief competitors.
  • Train your eyes for red flags. These include financial statements that haven’t been certified by auditors or that contain unusual loans or other transactions; frequent changes to the company name or business direction; prior SEC suspensions; and an outsize ownership stake in the company by an office or promoter.
  • Use a reputable broker. A good broker will help you act quickly if you do encounter a scam. NerdWallet maintains a list of brokers for penny stocks.

Arielle O’Shea is a staff writer at NerdWallet, a personal finance website. Email: aoshea@nerdwallet.com. Twitter: @arioshea.