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Why Do Penny Stocks Exist?

Penny stocks are shares of companies that are new to the market or have fallen on tough times. Their selling prices are often very low because they are facing financial distress or some other difficulty. Penny stocks actively trade in minor stock exchanges but involve a great degree of 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?

Penny stocks are not literally stocks that trade for pennies per share, although they can be. They are technically defined as stocks that trade below $3 per share. Some define 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 big long-term profits. In the penny stock world, everyone thinks they have a step on the next big thing. They are rarely right, 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 overall because of one home run stock pick. There is no shortage of amazing success stories out there related to penny stocks (and plenty of penny stock pick scams), but behind them are plenty of stories of failure. Penny stock traders must understand that this group of stocks are at the greatest risk to fall to zero.

What Happens to Stocks That Fall 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 towards zero it has become virtually worthless in the eyes on investors. No one wants to buy it and anyone that owns it can’t sell it. This can occur for a variety of reasons, most commonly when a company goes bankrupt. This can be due to operational issues such as an inability to supply product, financial problems, or simple mismanagement.

When this happens, the security is delisted from the major stock exchange on which it traded. In fact, this often occurs well before the stock reaches zero. The major stock exchanges have rules pertaining to what companies can belong 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?

Handing Stocks Their Pink Slips

Not all hope is lost for a delisted stock. Although it may be booted from a major stock exchange there are smaller stock exchanges out there where the downtrodden stocks go to play. Think of these stocks as the kids that get picked last for the kickball team; they still get to play, but 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 actually 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. In fact, 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 major 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 towards 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.

Miracles Can Happen

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 just what the doctor ordered. Note that stocks that do reach zero, usually cancel existing shares and reissue new shares once they emerge from Chapter 11 bankruptcy. The original shareholders must buy back into the new stock if they want to resume investment with the company.

How do I Pick Good Penny Stocks?

Like with non-penny stocks, we must do our homework when it comes to 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 major exchange stocks. Those interested in technical analysis may prefer these tools instead or in combination with fundamental analysis. At the end of the day, 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. If you are a buyer, don’t enter the research process with a bullish bias. Challenge your own 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? There are even companies out there that issue fraudulent shares, so tread carefully and get to know the company well.

A good first step is to spend time on the company’s website. 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. Companies that are more transparent may be better choices.

How Do I Trade a Penny Stock?

When you are ready to trade penny stocks, know that the trades can be entered on 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 make sure the investor is aware of the risks involved with penny stock investing. Before placing real money trades it is often best practice for beginner investors to start with paper trading. This means placing hypothetical trades that 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.

The Last Word

Penny stocks are also referred to as 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 that are brand new to the capital markets. They can also be more established companies that are facing financial difficulties and falling out of favor with investors.

While penny stocks can be viewed as appealing investment opportunities due to their seemingly bargain bin prices, they are often priced as such because they are unproven or have slim chances for success. However, a highly diligent research process has the potential to uncover a lucrative investment. But before you go digging under your car seat for some loose change, gain an thorough understanding of the high-risk nature of penny stocks.

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Leo Smigel

Based in Pittsburgh, Analyzing Alpha is a blog by Leo Smigel exploring what works in the markets.