Penny stocks can be attractive for traders because of their high volatility and potential for explosive growth. However, trading penny stocks is risky and it’s easy to fall prey to a scam if you’re not careful. In this guide, we’ll explain the pros and cons of penny stocks to help you decide if they’re right for you.
What is a Penny Stock?
According to the US Securities and Exchange Commission, a penny stock is any stock with a share price under $5. However, the term “penny stock” as it’s commonly used by investors is more specific. It refers to shares valued at less than $1 that are traded on over-the-counter (OTC) exchanges rather than on major stock exchanges like the New York Stock Exchange or NASDAQ.
OTC exchanges like the OTC Bulletin Board and the OTC Pink (often called the pink sheets) are fully electronic. There’s no minimum price for shares traded on these exchanges, so shares can be priced at as little as a few cents each – hence the term “penny stocks.”
Penny stocks are usually associated with small companies and startups. In addition, penny stocks are often issued by struggling businesses that don’t meet the financial requirements of the major exchanges.
What is the Allure of Penny Stocks?
While penny stocks have a mixed reputation among investors, they have an undeniable allure that keeps many traders coming back to them.
One of the most attractive things about investing in penny stocks is that they represent small companies that most investors have never heard of. So, there’s a chance that, through a combination of research and good luck, you could buy shares of a rapidly growing company at a bargain price years before it becomes the next Amazon. The potential upside is enormous if you find the right penny stock.
Another thing that some traders like about penny stocks is that they are typically much more volatile than higher-valued shares that trade on the major exchanges. This high volatility can have both benefits and drawbacks as far as profitability goes, but it certainly makes trading penny stocks exciting.
Pros of Penny Stocks
There are a few advantages to trading penny stocks that you can’t get when trading shares on the major exchanges.
Penny Stocks are Cheap
Penny stocks typically cost around one or two dollars per share, or sometimes even less. That means that individual investors can easily purchase thousands of shares – a holding that is typically reserved for institutional investors when talking about large-cap stocks.
That’s significant because it becomes possible for individual investors to take significant stakes in penny stock companies. Some penny stocks confer voting rights, so you can have a say in how a company is governed.
The fact that penny stocks are cheap can also be a good thing for investors with a small budget. Instead of buying a few shares of one stock, you can spend the same amount of money to buy many shares of many different stocks. That makes it easier to set up a diversified portfolio of penny stocks or to bet on a variety of potentially high-growth companies.
Penny Stocks are Volatile
The highly volatile nature of penny stocks can be an advantage for short-term traders. These stocks can experience massive price jumps in very short amounts of time. In fact, penny stocks are often a target for day traders and swing traders because of their high volatility.
Penny Stocks have Room for Growth
The fact that penny stocks often represent young companies means that they have plenty of room to grow. Penny stocks can become extremely valuable as small businesses go from losing money to turning their first profit, or as they begin to expand into new markets. Penny stocks can also benefit much more than stocks on the major exchanges from gaining investors’ attention since most high-quality penny stocks remain undiscovered by the majority of traders.
Cons of Penny Stocks
Unfortunately, penny stocks have a lot of drawbacks alongside their benefits. The downsides to penny stocks are enough to keep many risk-averse investors away.
Penny Stocks are Risky
Penny stocks are extremely risky. Most are offered by companies with limited track records and no history of profitability. Many of the companies behind penny stocks go bankrupt, leaving investors with worthless shares.
Worse, a large number of penny stocks turn out to be scams. Unlike for stocks trading on the major exchanges, OTC exchanges have few to no financial reporting requirements. So, its companies don’t share important financial data, and some have even been known to make up information when communicating with investors. Even for seasoned penny stock investors, it can be hard to tell the difference between a scam and a potentially lucrative investment.
Most Penny Stocks are Junk
Penny stocks aren’t worth much for a reason – many of the companies that issue these shares have shaky financials or questionable business models. The vast majority of companies that issue penny stocks will fail and go bankrupt rather than break out and move up to the major exchanges. Ultimately, when trying to pick winning penny stocks, the odds are against you.
Penny Stocks are Volatile
The volatility of penny stocks cuts both ways. While these stocks can rise in value extremely quickly, they can also lose value extremely quickly. Trading penny stocks isn’t for the faint of heart, and you need to have a plan for what to do if a stocks’ value begins to drop rapidly.
Penny Stocks have Low Trading Volume
A big part of the reason that penny stocks are so volatile is that they often trade with low liquidity. For most penny stocks, there are relatively few shares trading hands on any given day. That means that if you want to sell shares, you may have a hard time finding a buyer at the current market price – especially if you want to sell a large volume of shares. Penny stocks also typically have high bid-ask spreads, so you may be forced to sell shares for much less than the market price.
Trading Penny Stocks Comes with Additional Fees
Another downside to penny stocks is that trading them is typically more expensive than trading stocks on the major exchanges. Many brokerage firms have commissions for trading on the OTC markets, even if they offer commission-free trading on the major exchanges. You may also have to pay extra for OTC-specific data feeds, which aren’t included with many brokerage accounts. You could always opt-out of using the OTC markets and go with an app like Robinhood for trading your penny stocks; just be aware you may have fewer options than an OTC market.
Conclusion: Pros and Cons of Penny Stocks
Trading penny stocks can pay off big if you pick the right stock at the right time. These stocks are highly volatile and have a lot of room for growth. However, that volatility also means that penny stocks can lose value rapidly when you choose wrong. Penny stocks aren’t suitable for risk-averse traders and it’s important to carefully vet your investments when trading penny stocks.