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Penny stocks and how to invest in them
With potential for growth at a low cost, these investments can also be considered high-risk.
Penny stocks are an inexpensive way to diversify your investments and could multiply over time. But they’re also very risky investments because the companies are usually small, unestablished and fighting an uphill battle competing against other companies in their market. And yet, who doesn’t like an underdog?
What are penny stocks?
Penny stock are small-cap stocks that can be traded for less than $5. Most penny stocks aren’t listed on a major stock exchange, though there are always exceptions. Instead, they’re usually issued by new and unproven companies and are thinly traded directly between buyers and sellers on decentralized over-the-counter (OTC) marketplaces.
The US Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) lay out rules for brokers who offer penny stocks on some OTC marketplaces.
Because these stocks are priced so low, traded less often and have little financial backing, they’re referred to as anything from penny stocks to OTC stocks to micro-cap stocks.
Exchange-listed penny stocks
There are plenty of well-known stocks listed on the New York Stock Exchange or NASDAQ that also trade for less than $5 but are not considered penny stocks. For example, Genworth Financial (GNW), Hecla Mining (HL), Office Depot (ODP), Groupon (GRPN) and GoPro (GPRO) all traded between $1.50 and $5 in June 2020, but have market caps close to or more than $1 billion.
In this case, the SEC classifies the stock more by its market cap than its price:
- Large-cap: $10 billion+
- Mid-cap: $2 billion to $10 billion
- Small-cap: $300 million to $2 billion
- Micro-cap: $50 million to $300 million
- Nano-cap: Up to $50 million
Here are a few examples of penny stocks that are listed on major stock exchanges. Others include lesser-known pharmaceutical, tech and energy companies:
- Tuesday Morning (TUES), the discount retailer that filed for bankruptcy in May 2020
- Waitr Holdings (WTRH), the mobile food ordering company
- J. Jill (JILL), the women’s apparel retailer
- Kirklands (KIRK), the home furnishings retailer
- Apex Global Brands (APEX), the maker of Cherokee apparel and footwear
- HyreCar (HYRE), the company that rents cars to rideshare drivers
- Build-A-Bear Workshop (BBW), the store that lets kids create their own stuffed animal
- iFresh (IFMK), the East Coast Asian and Chinese supermarket chain
OTC penny stocks
The majority of penny stocks are found on OTC marketplaces. They don’t require minimum listing, so they’re easier to list on. The main OTC marketplaces include the OTC Bulletin Board (OTCBB) — regulated by FINRA, and the privately owned OTC Link, which has three parts: OTCQB, OTCQX and OTC Pink.
Not all brokerage accounts offer access to the OTC marketplaces. Some brokerages allow trades on large, foreign OTC stocks but not on OTC penny stocks.
Here are a few examples of OTC penny stocks:
- JCPenney (JCPNQ), delisted from the NYSE in May 2020
- Fannie Mae (FNMA), the government-sponsored enterprise officially named the Federal National Mortgage Association
- Frontier Communications (FTRCQ), the nationwide telecom company
- Medical Marijuana (MJNA), a CBD oil pioneer whose CEO was indicted in a real estate Ponzi scheme
- CV Sciences (CVSI), another CBD oil manufacturer
- TPT Global Tech (TPTW), a telecom company deploying 5G in several central states
Pros and cons of penny stocks
Some of the benefits and risks of investing in penny stocks are:
- Low prices. Investors can hold a diversified portfolio of penny stock companies without spending a lot.
- Potential growth. Newly listed companies can often present great growth opportunities if you pick the right ones. However, it could be a bumpy ride to the top.
- Thrilling. Penny stocks often see quick, significant prices changes, which can be exciting for investors with a high risk tolerance.
- Day trading. Because of their large price swings, penny stocks are often used by active day traders.
- High risk investment. Companies with penny stocks often come with a shorter financial track record compared to other listed companies and ETFs . Not all companies that list on an exchange do well, and a lot of penny stocks never become anything more.
- Illiquid. Because they’re largely unknown, penny stocks are often hard to buy and sell, and are vulnerable to manipulation like pump and dump schemes. Stocks could crash when investors push prices up drastically to draw in other investors, then sell out at higher prices.
- Volatile. Similarly, penny stocks often experience extreme stock price highs and lows within a matter of days, or even within the same day.
- Unregulated. There are much fewer, if any, standards that penny stocks have to abide by. With no requirements to file financial statements or to provide financial information can leave investors in the dark.
- No income. Penny stocks rarely pay any dividends, as all revenue is usually reinvested back into the company to help it grow.
Pattern day trading rule
FINRA has restrictions in place for day traders, placing limitations on your trading account if you qualify as a pattern day trader. While brokerages treat the rule differently, generally you’re considered a pattern day trader once you make four or more day trades within a rolling five-business-day period.
If that happens, your brokerage firm could prevent you from making further day trades. Set your account up for trading on margin and keep a balance of at least $25,000 to prevent being blocked.
Penny stocks vs. blue-chip stocks
The opposite of penny stocks are blue-chip stocks. Blue chips are large, listed companies that have been around for a long time and have an established, stable financial track record. Some of the biggest and most well-known companies are considered blue-chip stocks, such as Microsoft, Hershey’s and McDonald’s.
While penny stocks don’t pay dividends in most cases, blue chips almost always do.
Should you invest in penny stocks?
You could consider investing in penny stocks if you:
- Have a high risk tolerance.
- Are an experienced investor.
- Are willing to cut your losses if the stock price falls significantly.
- Have a long investment timeframe and are willing to ride out the volatility.
Tips for investors considering buying penny stocks
If you think you can handle the risks of investing in penny stocks, here are some tips to help you get started:
Do your research
This is important for all investments, but particularly high-risk investments like penny stocks. Blue-chip stocks are a low-risk option, with a long history of strong financial performance.
Plan a strategy and stick to it
Before you start buying, decide how much you’re willing to spend and choose the penny stocks you want to invest in. And if the stock falls, decide on a price you’d sell.
Don’t let emotions guide your decisions
It can be easy to get emotionally attached to a penny stock, as they’re often the underdogs in your portfolio. But when the stock price continually falls, don’t make excuses as to why you should keep it — stick to your strategy and leave your emotions out of your decisions.
Don’t get sucked in by the “cheap” prices
Penny stocks may appear to be cheap compared to others listed on major exchanges, but don’t base your investment decision purely on price. Basic factors that influence a company’s stock price is the demand for its shares and the number of shares it issues. The less demand from investors or the more shares issued, the lower the stock price. So consider why penny stocks are priced so low.
How to buy penny stocks
- Choose a stock trading platform. If you’re a beginner, compare stock trading platforms, and explore the stocks they trade. Some platforms like Robinhood offer limited access to foreign and unlisted companies, so you likely won’t find the ones you’re looking for. Others, like Ally Invest, offer more OTC stocks, still with a limited selection. The platforms that are tailored to professionals, like TD Ameritrade and Interactive Brokers, offer the widest selection of foreign and OTC stocks.
- Open your account. You’ll need your ID, Social Security number and details for an initial deposit.
- Confirm your payment details. You’ll typically need to fund your account with a bank transfer, though sometimes you can send a check.
- Find the stocks you want to buy. Search the platform for the penny stocks you want to buy. You could add safeguards like a limit order that locks in your maximum price so you won’t pay more than you expect.
Compare stock trading platforms for penny stocks
Penny stocks are fraught with risk, but some have the potential for growth. If you’re interested in trading penny stocks, make sure your brokerage account provides access.
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