What are Penny Stocks?

Do you ever wish that investing didn’t require so much money?

Sure, if you play your cards right, the amount you’ll have to initially put up pales in comparison to future gains. But – it’s still an amount of money whose absence is keenly felt. Stocks are expensive – that’s just the way things are. 💸

But is it, though? Not necessarily – and if what we’ve said above has troubled you in the past, then you’re going to find today’s topic, penny stocks, quite interesting.

Penny stocks are stocks that trade for very affordable prices and are issued by smaller, newer companies to raise capital for further growth. They’re risky, they often get a bad rap, and are often touted as a simple way to get rich quick. 

We can confirm that they are, indeed, risky and that they’re not a way to get rich quick – but they can be a great opportunity, provided that you take the time to really learn the ins and outs of this unique asset class.

If you’re not in a position to invest large sums of money, penny stocks offer an easy way to get into the market. But the fact that they are so accessible isn’t the only advantage that penny stocks have – even if you can afford to invest in ordinary stocks, there’s serious money to be made here.

But those potential profits go hand in hand with a lot of volatility that most investors simply aren’t prepared for. You can be – and we’re going to help you – so let’s start at the very beginning and explain what penny stocks are.

What Makes a Penny Stock? 🔎

The Securities and Exchange Commission defines penny stocks as stocks that trade for less than $5 per share. These shares are usually issued by small, up-and-coming businesses with low market caps to fuel further expansion.

Penny stocks aren’t often found on the major stock exchanges such as the NYSE and NASDAQ, although of course, exceptions exist. Instead, they’re usually traded over the counter, utilizing a broker-dealer network instead of a centralized exchange. 

Most penny stocks are traded through the OTC Bulletin Board (OTCBB) or the OTC Markets Group. The OTCBB does have a list of requirements that companies have to meet before they can be listed – however, these are far less strict than the requirements put in place by the SEC to list a company on a major exchange.

We should also mention pink sheet companies – these are stocks that are traded over the counter, but unlike with the OTCBB, there are no listing requirements. If that sounds like a red (or perhaps pink) flag to you – good. Pink sheet stocks are extremely risky, but there are a lot of legitimate companies that choose to list their stock this way.

Because of their low price, investing in penny stocks is very accessible – and even small changes in the stock’s price can end up netting you large returns that blow the average stock market returns out of the water. However, these stocks don’t have long track records or nearly as much transparency as regular stocks do.

Above all else, volatility is the one thing that defines penny stocks. That volatility can be a great opportunity for investors – but it also carries a lot of risk. The changes in stock price are amplified with penny stocks – and just as a small increase can make you a lot of money, a small decrease can end up costing you a lot.

How Penny Stocks Become Regular Stocks 🎓

Although it is a relatively rare occurrence, penny stocks can become regular stocks. Being listed on a major stock exchange allows a business to benefit from much greater visibility and liquidity.

The process of a stock moving from the OTC markets to a regular stock exchange is called uplisting. In order for a stock to be listed on a major stock exchange, it has to meet more rigorous standards, and the company in question has to compile with the SEC’s reporting requirements

For example, to meet NASDAQ’s listing requirements, a stock has to have a minimum price of at least $4, and the company in question has to have at least 1.25 million publicly-traded shares owned by at least 550 different shareholders, with the total value of the company’s stock being at least $45 million.

The NYSE has slightly different listing requirements for companies – at least 1.1 million publicly traded shares owned by at least 2,200 different shareholders and a total value of at least $100 million.

Both the NYSE and NASDAQ also require a price of at least $4 per share in order to list a security.

Once a business meets these requirements, it can apply for listing. The application process entails providing the exchange in question with a series of financial statements that prove that the company meets the listing requirements. If all goes well, the business will be accepted – and once it voluntarily delists from the OTC markets, it will be listed on the stock exchange in question.

The process of uplisting usually takes about four to six weeks, although it can be completed significantly faster, and is often followed by a spike in the stock’s price. Once a stock is uplisted, it may also have to change its ticker symbol, as the business in question might be required to put out a press release to all existing shareholders to notify them of the change.

How Regular Stocks Can Become Penny Stocks 👇

A penny stock becoming a regular stock is cause for celebration – a success story that is rarely seen. However, the reverse also sometimes happens – with regular stocks becoming penny stocks and being relegated to the OTC markets.

How does this happen? Well, we’ve already mentioned the initial standards that have to be met for a stock to be listed on one of the major stock exchanges. But the story doesn’t end there – businesses have to comply with rules and standards to remain listed – and if they can’t do that, they will be delisted, or removed from the exchange.

The standards that a company has to maintain in order to remain listed are less demanding – in the case of NASDAQ, a company has to maintain at least 750,000 outstanding public shares with a worth of at least $1.1 million.

The NYSE requires that a company maintains a market capitalization of at least $15 million, as well as at least 600,000 publicly held shares owned by at least 400 stockholders.

How Delisting a Stock Works 🚮

If a stock’s price remains under $1 for 30 consecutive days, it is in danger of being delisted. Both the NYSE and NASDAQ will send a company a non-compliance notification letter if that happens. 

Companies listed on NASDAQ then have 180 days to return to compliance by trading for $1 or more for at least 10 consecutive days. This is often achieved by doing a reverse stock split. In extraordinary cases, NASDAQ can require even tougher criteria for regaining compliance, if they have doubts that the business in question can sustain long-term compliance.

If they don’t manage to achieve that, they might get another 180 day compliance period if they meet all other continued listing requirements except the minimum share price.

If a company fails to meet compliance, NASDAQ will proceed with the delisting process. The company in question can then request a hearing where it can present a plan to regain compliance.

The NYSE is a bit more strict when it comes to delisting. After receiving a non-compliance letter, companies listed on the NYSE have only 10 days to present the exchange with a plan to increase the stock price within a certain timeframe, usually 4 to 6 months. 

If the plan is rejected or doesn’t work out, the NYSE will proceed with the delisting process. The NYSE also allows companies to appeal the decision to delist, which triggers a 25-day review period after which a final decision is made.

What Makes Penny Stocks Different ✅

Penny stocks are a pretty unique class of investments. They’re incredibly cheap, making them accessible to virtually any trader that wants to take a crack at them. They’re also incredibly volatile on average, with minor changes in price causing huge percentage gains or losses – if any security can be described as high-risk and high-reward, it is penny stocks.

The listing requirements for penny stocks require much less comprehensive financial statements. This means that it is much more difficult to thoroughly research stocks such as these, and even if you pull up all the possible relevant info, you’re still likely going to be working with much less information than with regular stocks.

Penny stocks also see lightning-quick changes in price because investors can easily purchase a lot of shares at once. Penny stocks are also quite susceptible to quick changes in price due to news.

While this might lead you to believe that penny stocks and day trading would be a match made in heaven, combining this volatile asset class with a risky method of investing should only be considered if you’re absolutely certain that you can maintain shatterproof discipline.

The low level of liquidity that is frequently seen in penny stocks often results in wide bid-ask spreads and can cause difficulties when it comes time to sell your investments, making these already volatile stocks even riskier.

Last but not least, one of the things that set penny stocks apart from other investments is the enormous gains that can be made. This doesn’t happen often, and it always goes hand in hand with a lot of risk, but the returns that you can get from penny stocks are unparalleled – with triple-digit returns being much more commonly seen than with regular stocks.

Risks of Penny Stocks ⚠️

As we’ve mentioned quite frequently in this article (for good reasons), penny stocks are risky investments. 

They’re volatile, there’s much less publicly available information on which to base your investment thesis, and they can see large increases or decreases in price in the blink of an eye. On top of that, a lot of these companies are relatively new – meaning that there’s no track record that you can look at to determine if the underlying business is healthy.

Another important risk to mention is that penny stock companies can and often do go bankrupt. While losses are always painful, investing in something like blue-chip stocks guarantees that your investments will never completely collapse and be worth $0 – with penny stocks, there are no such guarantees. And just in case this isn’t already obvious – a vast majority of penny stocks do end up failing.

Because of the frantic changes in price, and the large percentage gains or losses due to the low price of these stocks, the experience of trading them can frequently be nerve-wracking. Another thing to keep in mind is the recent influx of new traders into the market – many of whom are recklessly buying hyped-up stocks. The GME saga proved how dangerous that can be even with regular stocks – with penny stocks, the situation is even worse.

A lot of brokers are skeptical of penny stocks – as a result, they charge higher commissions for trading this type of security, or seek to discourage penny stock trading through other means, such as not accepting advanced market orders.

However, with all of that said, if you devise a good trading strategy and stick to it, do proper research before investing, and practice proper risk management, penny stocks can be an incredibly profitable endeavor.

The Good and the Bad with Penny Stocks

Penny Stocks Scams 🚨

One of the more significant drawbacks of penny stocks that we haven’t yet touched on is scams. Because of the reduced financial transparency and much more lax listing requirements, penny stocks are often used by unsavory types to lure in naive or inexperienced investors and defraud them.

Penny stock fraud comes in plenty of shapes and sizes. Let’s take a look at the most common forms.

Pump and Dump ❌

The first and most common is the pump and dump scheme. In a pump and dump, an investor with enough capital buys up a lot of shares at once – because this increased level of trading volume will be noticed by other investors, it will spur interest in the stock in question. This leads to a buying spree which drives the price of that share up – at which point the original investor sells off his or her shares at a much higher price.

Short and Distort ❌

The opposite of a pump and dump is the short and distort scam. Because penny stocks are particularly susceptible to price changes resulting from bad news, scammers sometimes pick a penny stock, short sell it, then spread damaging rumors about the company in question, causing the stock price to drop so that they can lock in profits.

Gurus, Newsletters, and Promotions ❌

Because penny stocks are often touted as an easy way to get rich quickly, the internet is full of self-described penny stock gurus that promise large returns if you subscribe to their newsletters. 

This sounds too good to be true – because it is. In reality, some of these investors purchase a large number of shares, recommend the stock in question to their subscribers, and when that causes an increase in price, they sell their shares. This works quite similarly to a pump and dump but is legally in a grey area.

On top of that, penny stocks are sometimes marketed via email spam campaigns. It doesn’t take much financial or technological literacy to deduce that these are scams, but let it be mentioned just in case.

Shell Companies ❌

Because financial transparency standards are much less stringent for penny stocks, a lot of the businesses behind penny stocks, particularly those listed in the pink sheets, are shell companies – businesses that don’t actually do anything but are instead founded for the sole purpose of selling stocks.

One of the most notorious examples of this type of fraud is the case of Zirk de Maison, who created five penny stock companies. These companies were purported to be involved in a variety of businesses from precious metal extraction to social media – but none of them actually did anything.

This didn’t stop him and his co-conspirators from artificially buying and selling shares among themselves, which drove up the price of the stocks. Combined with unscrupulous promoting and high-pressure sales tactics, more than $39 million was embezzled before federal charges were pressed.

How to Avoid Penny Stock Scams 💡

Although common sense and good instincts will kick in most of the time, it’s still useful to know the telltale signs of penny stock scams.

For one, don’t believe the hype – penny stock gurus and promoters do not have your best interest at heart. No one is going to do your research for you – you have to lay the groundwork for success by yourself.

Avoid pink sheet stocks that offer little in the way of available information. Transparency not only signifies that business is legitimate, but it also gives you something to base your decision to invest on.

Unexplained increases in trading volume or stock price often point to pump and dumps or market manipulation. If you can’t wrap your head around why a stock is seeing increased interest, do not invest in it.

How Are Penny Stocks Created? 🐣

When two stocks love each other very much, a stork delivers a penny stock in nine months’ time. Just kidding – unsurprisingly, things are a bit more complicated than that.

When a business decides that it wants to issue stock, it goes through a lengthy process known as an initial public offering. 

The first step in that process is underwriting – in which a company hires a third party, often an investment bank or an attorney, to gauge risks, ensure compliance and registration with the SEC, file all the relevant documentation, and estimate the optimal offering price and amount of shares.

Once that is done, financial statements are made public, and once the SEC approves of the IPO, initial orders are collected and the stock is sold to investors participating in the IPO. After that, the stock can begin trading on the OTC markets when it applies for a listing.

Penny Stock Regulation 🏛

Seeing as how penny stocks are as volatile and risky as they are, it comes as no surprise that they’re subject to a lot of regulations. There’s no need to worry – most of that stuff goes on behind the scenes, and likely won’t affect you as a trader in any way. However, a crash course in penny stock regulations is a must if you want to truly understand the subject.

The SEC and FINRA regulate the trading of penny stocks in the United States. Every broker-dealer that wants to deal in penny stocks has to comply with the Securities Exchange Act of 1934.

So, what does the Securities Exchange Act of 1934 entail when it comes to penny stocks? Mostly boring legalese, but it also sets in place a couple of practical requirements that have helped to weed out untrustworthy brokers, such as:

• Customers must be shown a disclosure document that outlines the risks of trading penny stocks and the customers’ rights.
• Quoted prices have to be disclosed and confirmed before a transaction is completed.
• Brokers have to be upfront and transparent with regard to how much they earn per transaction.

However, while this was an important step toward improving the security and reliability of the penny stock market, it wasn’t enough. Further steps were taken with the Penny Stock Reform Act of 1990. 

This piece of legislation granted the SEC administrative purview over penny stock brokers, issuers, and dealers. It also set in place regulations that require brokers and dealers to disclose information about the penny stock market at large and specific penny stocks to customers, and also promoted the founding of an electronic marketplace where penny stocks can be quoted.

Comparing Different Penny Stock Markets ⚖️

Penny stocks are traded across several different markets, each with its own characteristics and listing requirements. We’ll go over the most important ones here so that you’ll always have a handy refresher course on what to expect from any given penny stock depending on which market it is traded on.

NYSE / NASDAQ Penny Stocks ✔️

Penny stocks listed on the major stock exchanges are the most reputable and least volatile. They still represent a much riskier investment than a regular stock would, but it is much less likely that the underlying business will declare bankruptcy and cause your investments to go to zero.

On top of that, penny stocks that are listed on these exchanges are much less likely to be subject to shady business dealings – as the SEC and the exchanges themselves demand a much higher standard when it comes to financial transparency.

OTC Penny Stocks ✔️

OTC penny stocks are traded via the OTC Markets Group or the OTC Bulletin Board. As the OTCBB is slowly being phased out, most OTC penny stock trading takes place through the OTC Markets group nowadays.

The OTC market is divided into several tiers – OTCQX, OTCQB, and OTC Pink. Penny stocks cannot be listed on the OTCQX – however, the OTCQB is a great place to find penny stocks that meet at least some degree of financial transparency but still can’t meet the requirements for listing on a large stock exchange.

Pink Sheet Penny Stocks ✔️

Pink sheet penny stocks have no financial standards or reporting requirements. In fact, these stocks don’t even have to be registered with the SEC. Pink sheet stocks are divided by how much information is available on them, and how recent that information is.

While pink sheet stocks can also be quite profitable, they take the already risky concept of a penny stock and crank it up to eleven. Because of this, you should be extremely careful if you decide to invest in this type of penny stock.

Conclusion 🏁

So, there you have it. Hats off for making it to the end of this guide. We hope that you now have a solid foundation of knowledge when it comes to penny stocks – and if you’re still unsure, feel free to go over anything that’s still unclear again – this guide isn’t going anywhere.

Although these stocks aren’t big, they are notorious. They’re risky, volatile, and difficult to trade successfully – but at the end of the day, they’re still stocks. Most of the infamy regarding penny stocks is simply due to a lack of knowledge – and if you keep on learning, you’ll find that it is a dynamic, interesting market full of opportunities – one that you can invest in while still keeping the level of risk that you’re exposing yourself to reasonable.

Get Started Trading Penny Stocks