What Are Penny Stocks? | Bankrate (2024)

Penny stocks are small companies whose shares trade for a relatively low price. They may look cheap compared to popular stocks such as Amazon or Apple, but often they’re much more expensive, despite their lower price tag. Penny stocks are among the market’s most dangerous stocks, so you may pay a much greater price than you first expect, including potentially losing all of your investment.

Here’s what a penny stock is and why it’s so risky to investors looking to grow their wealth.

What is a penny stock?

The exact definition of a penny stock varies, but typically they include stocks trading for less than $5 per share all the way down to even fractions of a penny. But usually when people say penny stocks, they’re talking about those that trade for less than a dollar. Despite this lower price, penny stocks often don’t trade as many shares as their higher-priced rivals.

Penny stocks are not usually listed on major exchanges such as the New York Stock Exchange or Nasdaq. Instead, they’re often traded on what’s called the pink sheets or the over-the-counter (OTC) market. Shares listed here are often very risky, though sometimes a hidden gem may lie in wait.

Penny stocks are highly speculative and include some of the market’s smallest companies, including those that have been recently established. But penny stocks also include some of the market’s shadiest companies, such as outright frauds and other pump-and-dump scams, a fraud in which paid promoters tout a stock to get it to rise so that insiders can sell at a higher price.

Because they’re not listed on a major exchange, the firms behind penny stocks usually aren’t as transparent about their financials or governance as those on an exchange. And if they’re small enough, the Securities and Exchange Commission (SEC) doesn’t require financial disclosure, either.

All of these factors make penny stocks much more risky than an exchange-listed stock, which means you’ll need to have a high risk tolerance to invest.

Can you make money with penny stocks?

Yes, you can make money with penny stocks, but you can also make money playing the lottery, though you probably won’t. To make money in penny stocks, you have to be able to separate the good companies from the bad, and that means you have to be able to analyze companies. If you don’t have that skill, the chance of you doing well in penny stocks is almost zero.

Your best bet is keeping up with the financial stats, emerging news and any SEC filings to help gather details. You may also want to contact the company for further info, including their financial data. It’s not a good sign if the company won’t give it to you.

For the most part, you’ll want to search for the following types of companies:

  • Promising start-ups with an inventive idea or clever business plan
  • Those announcing a profitable partnership or endeavor
  • Those with strong fundamentals and the ability to compete in their industry

Unfortunately, these traits are also what the pump-and-dump scams highlight, promising a breakthrough in whatever the day’s hot new technology is (3D printing, biotech, solar). They ensnare newer investors with promises of wealth from almost-on-the-verge “blockbusters.”

In addition to doing your own research, find someone who knows the industry well and ask them to mentor you on how to find the best penny stocks. You’ll be much better off if you are able to learn from someone else’s mistakes instead of making them all on your own.

“Investors in penny stocks should be prepared for the possibility that they may lose their whole investment,” according to the SEC. “Or an amount in excess of their investment if they purchased penny stocks on margin.”

If you can’t understand the business, then you probably shouldn’t invest.

Potential risks of penny stocks

While penny stocks entice investors with potential gains, you need to be aware of many risks:

  • Lack of liquidity: Penny stocks are often illiquid, meaning it can be difficult to buy or sell your shares quickly without impacting the price.
  • Unprofitable: Many penny stocks represent a stake in a company that has not and will not generate earnings for its shareholders. Earnings and the potential for earnings are what give stocks value, so a perpetually unprofitable company isn’t worth much.
  • Frauds: Some penny stocks even fall into the category of outright fraud. Whether it’s a pump-and-dump scheme or a company that’s filing false financial statements, you should be on the lookout for penny stock frauds.

3 common myths about penny stocks

Many of the myths surrounding penny stocks are dangerous and simply untrue, helping investors make critical mistakes that could cost them serious money.

Here are the most common ones:

1. “Penny stocks have high potential, but they’re undiscovered”

A few penny stocks may have legitimately high potential, but the vast majority of stocks are trading so cheaply because they’re terrible businesses or simply fraudulent. Penny stocks are much more likely to be a poor company on the verge of disappearing than a hidden gem.

2. “If the stock goes up just $1, I’ll double my money”

New investors say this line all the time. Or perhaps a similar one, “The stock is 10 cents now, and if it goes up to a $1, I’ll have 10 times my money.” While the math is fine, the logic isn’t based on how the market actually works.

Over time stocks rise and fall based on their profitability and investors’ expectations of their future profitability. For a stock to be worth 10 times its price, it has to show the market a lot of future potential. But penny stocks almost never show this kind of potential. Sure, they may spike from time to time, but they won’t enjoy the kind of sustained increase that can make you rich.

3. “This $1 stock is cheaper than that $100 stock”

When new investors find penny stocks, many love that they can buy thousands of shares, while they can afford only a few shares of a high-priced stock. If the stock is trading at $0.25, for example, they could buy 1,000 shares for only $250. A low price makes it appear the stock is cheap, but it rarely is. Then they might assume that if the stock goes up $1, they’ll make $1,000.

However, professional investors measure how expensive a stock is by comparing it to its earnings (the P/E ratio) or other similar metrics. That is, what your share in the earnings of the business is for the price that you pay for that share. On this basis, a profitable company whose stock trades at $200 is much cheaper than an unprofitable penny stock at any price.

Many people who invest in penny stocks lose their money altogether because they start with these mistaken beliefs and their penny stock never recovers.

Bottom line

If you’re interested in penny stocks, you’ll need to be an excellent analyst who can pick the good businesses from the bad businesses. Plus, you have to avoid the out-and-out frauds entirely. Savvy investors stick to businesses they can understand or instead opt to invest in diversified index funds, where they don’t need to understand the businesses in order to beat the pros.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.

What Are Penny Stocks? | Bankrate (2024)

FAQs

What Are Penny Stocks? | Bankrate? ›

But usually when people say penny stocks, they're talking about those that trade for less than a dollar. Despite this lower price, penny stocks often don't trade as many shares as their higher-priced rivals. Penny stocks are not usually listed on major exchanges such as the New York Stock Exchange or Nasdaq.

Why penny stocks are the best? ›

Investors who like penny stocks perceive them as having several attractive features: the low stock price, which allows investors to buy a relatively large number of shares, and the potential for quick gains." Some penny stock investors may buy tens of thousands of shares for a relatively low amount of money, hoping ...

Are penny stocks ever successful? ›

Unfortunately, people tend to only see the upside of penny stocks, while forgetting about the downside. A $0.10 stock can just as easily go down by $0.05 and lose half its value. Most often, these stocks do not succeed, and there is a high probability that you will lose your entire investment.

Are penny stocks very risky? ›

Penny stocks are among the market's most dangerous stocks, so you may pay a much greater price than you first expect, including potentially losing all of your investment. Here's what a penny stock is and why it's so risky to investors looking to grow their wealth.

Are penny stocks illegal? ›

Penny stocks are legal, but they are often manipulated. Penny stocks get their name because of their low share price. Any stock trading below $5 a share is generally considered a penny stock.

Are penny stocks high risk? ›

Penny stocks come with high risks and the potential for above-average returns, and investing in them requires care and caution. Because of their inherent risks, few full-service brokerages even offer penny stocks to their clients.

Is Tesla a penny stock? ›

Before they made it big, Apple, Microsoft, Netflix, Nvidia, and Tesla all started as penny stocks. You could have bought stock for pennies and sold it for hundreds, or even thousands, of dollars per share. That's the dream for most penny stock investors.

Was Amazon once a penny stock? ›

Amazon (NASDAQ: AMZN)

At its IPO in 1997, it traded under $2 a share. It graduated from its penny stock designation in 1998.

Do penny stocks ever recover? ›

They can rebound emphatically when heavily shorted, rewarding those who invest judiciously during their undervalued phases. Amidst market volatility, investors, eager for robust returns, are increasingly drawn to these dynamic penny stocks.

Can you make money on penny stocks? ›

It is possible to make money with penny stocks. Then again, it's technically possible to make money with any type of stock. Successful investors usually focus on the potential for their stock picks, regardless of price, to gain value over the long term. There are plenty of good reasons to invest in small companies.

Is penny stocks a good buy? ›

Penny stocks come with high risks and the potential for above-average returns, and investing in them requires care and caution. Because of their inherent risks, few full-service brokerages even offer penny stocks to their clients.

Was Apple a penny stock? ›

(NASDAQ: AAPL). Apple wasn't always one of the largest tech companies in the world. In fact, hardly anyone knew about the company and its products for years. Back in the early 2000s, AAPL traded for under 80 cents per share — a legit penny stock.

Was Amazon a penny stock? ›

Amazon (NASDAQ: AMZN)

At its IPO in 1997, it traded under $2 a share. It graduated from its penny stock designation in 1998.

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