Penny stocks are shares of companies new to the market or have fallen on tough times. Their selling prices are often very low because they face financial distress or some other difficulty. Penny stocks actively trade in minor stock exchanges but involve significant risk.
We often hear about penny stocks and may already have a sense that their small stature makes them high risk but potentially high return investments. But why do they exist in the first place? Here we explore why penny stocks get to where they are and their function in the broader trading world.
Many speculative traders are lured by the prospect of finding a company that can right the ship and become a lucrative investment. But understanding why a penny stock is so cheap in the first place is a critical pre-requisite to the research process.
What are Penny Stocks?
Although they can be, Penny stocks are not stocks that trade for pennies per share. They are technically defined as stocks that trade below $3 per share. Some describe them as stocks under $5 per share. As a group, they are considered the riskiest of stocks. They have earned this reputation because they represent equity in struggling or unproven companies.
But of course, with high risk can come high reward. Traders dabble in penny stocks because they offer the hope for quick profits or, with patience, significant long-term gains. Everyone thinks they have a step toward the next big thing in the penny stock world. They are rarely correct, but sometimes through diligent research (or blind luck), they strike it rich.
A penny stock trader could strike out on four out of five stock picks but still be profitable because of one home run stock pick. There is no shortage of fantastic success stories related to penny stocks (and plenty of penny stock pick scams), but behind them are plenty of failure stories. Penny stock traders must understand that this group of stocks is at the most significant risk of falling to zero.
As stock prices approach zero, penny stocks are born. This may sound strange, but let’s take a step back and examine why. When a stock price drops to zero, it becomes virtually worthless in the eyes of investors. No one wants to buy it, and anyone that owns it can’t sell it. This can occur for various reasons, most commonly when a company goes bankrupt. This can be due to operational issues such as an inability to supply products, financial problems, or simple mismanagement.
When this happens, the security is delisted from the major stock exchange it traded. This often occurs well before the stock reaches zero. The major stock exchanges have rules pertaining to what companies can belong to and how a stock must perform to maintain its membership. The New York Stock Exchange requires that a stock’s selling price stay above the $4 level. If it does not, it can be delisted. But where does the stock go? Are there a bunch of $2 and $3 stocks floating around with no place to trade?
Not all hope is lost for a delisted stock. Although it may be booted from a significant stock exchange, there are smaller stock exchanges where the downtrodden stocks go to play. Think of these stocks as the kids who get picked last for the kickball team; they still get to play in the smaller field down the road.
These small-priced stocks become over-the-counter (OTC) securities. They are said to trade in the OTC market and appear on so-called ‘pink sheets’. Yes, just like when someone loses a job and is said to be handed a pink slip. Except pink sheet stocks are still employed in the OTC market and can be bought and sold by speculative traders.
The OTC market is a huge trading forum that can see over 5 billion shares worth over $1 billion trade hands on any given day. Its players are high-risk investors seeking to strike it rich by investing in companies that may be on the comeback trail. Other short-term traders play in this sandbox to capitalize on the inherent volatility in penny stocks by entering and exiting positions within days or even minutes. The volatility of the OTC market is the source of its appeal to many of its participants.
There is less oversight and regulation when it comes to the OTC market compared to the more popular significant exchanges. In the OTC market, stocks are no longer evaluated for their quality. A lack of checks and balances makes it easier for these stocks to drop toward zero and into ‘security obscurity’. Like the last pick in the NFL draft, a penny stock can quickly lose interest among traders and become Mr. Irrelevant. The more obscure nature of penny stocks generally makes them unappealing to the big institutional investors like mutual funds, pension funds, and hedge funds. This leaves a playground of mostly individual traders clamoring to discover the winning long-shot horse.
Some companies and their stocks get resurrected from the dead. A depressed company may receive new funding or conjure up a turnaround plan to reinvent itself. This can spark renewed interest from investors. Gradually, or sometimes suddenly, buyers and sellers return to the table and want to trade the penny stock.
A stock can even get its act back together and return to the major exchanges. Sometimes a delisted stock may return to growth. Or it could have been experiencing growth all along and just needed a kick in the pants. Taking time to reorganize its finances or redefine its business model can be what the doctor ordered. Note that stocks that reach zero usually cancel existing shares and reissue new shares once they emerge from Chapter 11 bankruptcy. The original shareholders must buy back the new stock if they want to resume investment with the company.
Like with non-penny stocks, we must do our homework regarding penny stocks. This often requires a much deeper dive into the financials of the company. It can mean seeking out the same fundamental qualities that we look for in significant exchange stocks. Those interested in technical analysis may prefer these tools instead or combined with fundamental analysis. You want to build an investment thesis that you can get your head around and feel comfortable enough with to hand over your hard-earned money.
Be critical of the company you are researching. Don’t enter the research process with a bullish bias if you are a buyer. Challenge your thinking and push yourself to think outside the box. What do I see in this company that perhaps the market doesn’t see or appreciate? Even companies out there that fraudulent issue shares, so tread carefully and get to know the company well.
An excellent first step is to spend time on the company’s website. Please get to know its operating history, products or services, market, and competitors. If possible, interact with the company’s investor relations department to learn more about the business and where it is headed. If the company doesn’t have much documentation around its financials or strategy, this could be a bad sign. More transparent companies may be better choices.
When you are ready to trade penny stocks, know that the trades can be entered on a regular trading platform like Fidelity, Schwab, or TD Ameritrade. Most major brokerage platforms permit the buying and selling of penny stocks up to 10,000 shares. If you want to place a trade beyond 10,000 shares, the brokerage will often require a one-time verification process to ensure the investor is aware of the risks involved with penny stock investing. Before placing actual money trades, it is usually best practice for beginner investors to start with paper trading. This means placing hypothetical trades in a portfolio of ‘Monopoly money’ and keeping track of the results. In this way, investors can learn from successes and failures before putting funds at risk.
Penny stocks are also called micro-cap or nano-cap stocks because of their tiny company sizes and values. They represent shares of small public companies that trade at ultra-low prices. Penny stock companies can be upstart businesses brand new to the capital markets. They can also be more established companies facing financial difficulties and falling out of favor with investors.
While penny stocks can be viewed as appealing investment opportunities due to their seeming bargain bin prices, they are often priced because they are unproven or have slim chances for success. However, a highly dynamic research process has the potential to uncover a lucrative investment. But before you go digging under your car seat for some loose change, gain a thorough understanding of the high-risk nature of penny stocks.