What Exactly Is A Penny Stock?

Penny stocks are often the subject of wild fascination. For example, they acted as the foundation for Jordan Belfort's real-life market manipulation scheme that was later dramatized in "The Wolf of Wall Street." But penny stocks aren't just a scam. In fact, investors can utilize penny stocks — if leveraged appropriately, of course — to create sizable growth when market conditions turn just right.

The penny stock is an intriguing financial instrument, but it's one that must be used sparingly if it is to successfully enter a responsible trading strategy. Many investors steer clear of these low-cost stock commodities, but often this is done out of ignorance of their value rather than a dedicated choice to avoid the asset type. In reality, penny stocks can be a quality means of infusing new high-risk, high- reward assets into your investment profile. Yet, great care must be taken in order to get the balance working in an investor's favor. Likewise, plenty of research must go into any purchase in the penny stock space in order to make it worth your while.

Penny stocks are ultra-low-cost company shares

The long and short of the penny stock market is that it's home to the lowest-cost stocks around. Generally, the SEC defines a penny stock as a company share trading for less than $5, but many penny stocks can be found at roughly the single dollar mark — making them true to their name.

Penny stocks, therefore, are shares of companies that investors can buy with ease, even if their portfolio value isn't all that high. The concept seems like a valuable one on the surface. Purchasing hundreds or even thousands of shares can see your value skyrocket if the company begins to gain value. Increases in penny share value can see profit margins dramatically move skyward.

Yet, the inverse is also true of penny stocks; a small dip in value can lead to gigantic percentage points off the buy price of a penny stock's shares. Many penny stocks are shares of companies that are new to the market or have experienced a dramatic fall from grace. For instance, Hertz is currently trading at about $7.50 per share (as of March 22, 2024), but during the pandemic, the company liquidated assets and filed for bankruptcy, tanking value down well below the $1 mark.

Most penny shares trade 'over the counter'

Over-the-counter trading is a standard practice in the investment space, and it's not something that should be inherently feared. Forex trading, for instance, takes place in an OTC market rather than on a stock exchange. A tip if you're a beginner investing in Forex, is that it's often a good idea to play around with a practice account, and the same kind of learning curve exists for penny stocks.

Where care needs to be taken is in the rules governing the OTC space. There are fewer regulations surrounding shares listed in this manner than on the NYSE or Nasdaq, so greater attention to detail must be paid. Not all companies trading over the counter are inherently bad, and many are just small brands that are new to the public domain and can't afford the listing fees — a $250,000 expense to join the ranks of NYSE-traded companies, for instance.

High volatility often means boom or bust

It nearly goes without saying, but one of the most important considerations with any penny stock is the volatility of the asset type. Penny stocks, by nature, are far riskier investments than standard stock purchases. Companies listed on the New York Stock Exchange or elsewhere are firmly established businesses that can point to a lengthy track record of success. Over-the-counter shares don't typically sport this kind of lengthy public history.

Penny stocks are often small enterprises that are looking for market exposure in an effort to blow up in volume and evaluation. But with little public history or an established customer base, these newer companies might end up going out of business rather than finding new legs and beginning to compete with a new intensity. Investments in low-dollar stocks don't typically stand still. An up-and-coming brand is often one on the cusp of success, but taking this stride forward comes with great risk. Some businesses will overextend themselves and ultimately go bankrupt as they attempt to reach that next level. The penny stock marketplace, therefore, is a marketplace that's characterized by high potential rewards alongside a massive level of risk.

There's a illiquidity risk with penny stocks

One feature that may be surprising to routine stock investors in the penny stock space is that these companies may occasionally become fairly illiquid. For most trades on the stock market, placing a sell order is rapidly followed by the actual sale of listed commodities. But in the small-dollar market, there may be a limited supply of active buyers, leading to a scarcity in buy orders seeking sellers to pair with.

Illiquidity is a problem that's typically reserved for solid growth assets. The tradeoff isn't quite so substantial when there's a predefined interest rate or maturity value, but in the case of highly volatile commodities, the inability to sell on your own terms can be disastrous. Getting out of an investment at its peak is the target for many stock traders, and with a well-timed sale the ability to capitalize on price appreciation is virtually guaranteed with other stock market holdings. However, in the OTC market, there won't always be buyers lining up to invest in these niche products.

Companies trading so low may be hard to research

Lastly, any investment you're considering pursuing should be preceded by considerable research. Investigating a company's financials or a commodity's potential return is a cornerstone piece of the investment puzzle. If you don't know what you're investing in, it can be difficult — if not impossible — to make educated judgments about your potential for targeted return. Unfortunately, with penny stocks, there isn't always a wealth of data available to peruse. Companies listed in over-the-counter trading spaces may have just gone public, meaning there simply isn't any data to be found on the brand.

Even among established brands however, companies trading in these circles don't have the same reporting requirements that govern larger marketplaces. This means that companies have the ability to behave in a more guarded manner. Not every brand trading in an OTC market will be looking to hide information or act immorally, but the potential for this behavior remains a feature that you must stay on the lookout for. Penny stocks and the avenues available to invest in them can be a highly valuable segment, but the ability to gain a complete understanding of a company's outlook is muted at best in this space. Therefore, great care should be taken when investing in any penny stock.