What Are Penny Stocks and What Makes Them So Risky?

“People don’t buy stock; it gets sold to them. Don’t ever forget that,” said Jordan Belfort, the main character portrayed by Leonardo DiCaprio in the movie ‘The Wolf of Wall Street’. Belfort knew what he was talking about; he was the founder of a boiler room brokerage firm that specialized in selling penny stocks using dishonest sales methods.

Penny stocks are high-risk investments known for their extreme volatility and huge price swings. Most investors tend to avoid these stocks as they have a long track record of scam, fraud and manipulation. For others, investing in penny stocks means the possibility of big returns in a short time. These investors believe that the issuer, usually an early-stage company, may become the ‘next big thing’. Some search for fallen angels or hidden gems.

Only a small share of penny stocks have real upside potential. The vast majority is just poor investment. Finding the good companies is a bit like finding a needle in a haystack. You need a lot of time and research. And nerves of steel.

Investing in Penny Stocks

What is a penny stock?

Penny stocks refer to securities issued by “very small” companies that are priced under $5, according to the definition of the US Securities and Exchange Commission (SEC). Some penny stocks are listed on a formal securities exchange, like NASDAQ, but most of them are traded over-the-counter (OTC) through a broker-dealer network.

Penny stocks are considered speculative investments because they carry high risks. They are usually thinly traded, illiquid securities. It means that traded volumes are low and the number of potential buyers and sellers is limited. Therefore, it’s difficult to sell them at a good price. This is one of the reasons why they are considered riskier than other, more liquid securities.

“Consequently, investors in penny stocks should be prepared for the possibility that they may lose their whole investment.” —SEC

Penny stocks can be the shares of startups or companies at their early development stage, which cannot yet meet the listing requirements of a formal stock exchange. However, they can also be stocks that have been delisted from big exchanges because they no longer meet even the minimum listing standards required by an exchange. When these issuers are kicked out from an exchange, they can still trade on OTC markets. Although a delisting doesn’t necessarily mean that a company will go bust, it is not a good sign as it almost always results in a loss of value and reputation.

A recent example is Chinese coffee company Luckin Coffee, which is now traded over-the-counter as a penny stock after being delisted from the NASDAQ in June 2020 because of a fraud scandal The shares were trading at around $4.4 per share as of November 2020, after reaching a record-high $50 in January. Luckin went public in May 2019.

In the next chapters, we show you where listed and OTC penny stocks are traded in the US. As a general rule, penny stocks that are traded on formal exchanges are considered a lot less risky than those on OTC markets because they have to meet the strict requirements of an exchange.

Investing in Penny Stocks

Where are penny stocks traded?

Penny stocks are traded primarily on OTC markets, where there are no strict disclosure requirements and regulatory control. OTC securities are thus considered riskier than those traded on regulated exchanges like the NYSE and NASDAQ. If you prefer less risky investments, you can find penny stocks listed on these big exchanges, too.

Main exchanges where penny stocks are listed:

  • NYSE
  • NYSE American

Quotation services for OTC penny stocks:

  • OTC Bulletin Board
  • OTC Markets Group (OTCQX, OTCQB, Open Pink Market
  • Grey Market

Penny stocks listed on stock exchanges

Some penny stocks are traded on big stock exchanges, like the New York Stock Exchange (NYSE), NASDAQ and the NYSE American, formerly known as Amex. These stocks can be found with the help of stock screeners, where you can search for stocks trading under $5 at each exchange. 

The NYSE American, the former Amex, is now a listing place for companies that do not meet the requirements of the NYSE. These are typically younger, smaller firms in their early stages of growth. There are both small-cap and micro-cap stocks.

“Drawing on its heritage as the American Stock Exchange, NYSE American is an exchange designed for growing companies, and offers investors greater choice in how they trade.” —NYSE American

Trading off the exchanges: OTC penny stocks

Penny stocks that are not listed on any exchange are quoted on OTC systems, like the OTC Bulletin Board (OTCBB) and the OTC Markets Group. Keep in mind that these aren’t regulated stock exchanges; they are interdealer quotation services. Thus, there are no strict listing and maintenance standards and requirements that must be met by the issuers. This is what makes them a lot riskier than the formal exchanges.

  • OTC Bulletin Board

The OTCBB is a quotation service for securities that are not listed or traded on the NYSE, NASDAQ or any other national securities exchange. OTCBB is operated by the Financial Industry Regulatory Authority, or FINRA. It is a government-authorized not-for-profit organization that oversees US broker-dealers.

“Any reference to the OTC Bulletin Board should never include the word ‘listed’ and should not be associated with NASDAQ.” —OTCBB

  • OTC Markets Group

OTC Markets Group organizes securities into three marketplaces based on the amount and quality of available information. There are two premium markets, OTCQX and OTCQB; the third marketplace is the Pink Open Market. Retail investors can trade OTCQX, OTCQB and Pink securities through a FINRA-registered broker-dealer.

“To create better informed and more efficient financial markets, we organize securities into three markets based on the quality and quantity of information companies disclose. These are the OTCQX (the Best Market) and OTCQB (the Venture Market) beside the Pink Market (the Open Market).” —OTC Markets

The Pink Market, or Pink Sheets, is the riskiest of the three marketplaces operated by the OTC Markets Group. It is an open marketplace for securities with no financial standards or reporting requirements. You will find here penny stocks as well as distressed, delinquent, illegitimate shell and dark companies not willing or able to provide information to investors. It’s best to avoid this market because it’s packed with worthless securities and scams. 

The only way to remove a company from the Pink Market is for all of the broker-dealers to stop quoting it. You cannot delist these stocks because this is not an exchange, so the stocks were never formally listed in the first place.

The name “Pink Sheets” comes from the color of paper on which quotes of share prices were once published. Today they are, of course, electronic quotes.

    • There is also a so-called Grey Market. It is for securities that are not currently traded on the OTCBB, OTCQX, OTCQB or Pink markets. Broker-dealers are not willing or able to publicly quote these securities because of a lack of investor interest, company information or regulatory compliance.

Investing in Penny Stocks

How to invest in penny stocks?

What are the main risks of investing in penny stocks? 

As most penny stocks are not traded on big stock exchanges, it is difficult to find publicly available information on them. The NASDAQ and the NYSE have specific listing and maintenance standards, which are closely monitored and enforced. Companies listed on such exchanges have strict reporting obligations, including quarterly and annual financial reports. Data and information on OTC penny stock issuers is often unreliable or simply unavailable. 

Unlike large- and medium-cap stocks, penny stocks are thinly traded securities, so they are not heavily followed by analysts and investors. While investors can easily get analyst estimates for future revenues and profits of blue chip companies like Pfizer or General Motors, there’s very little or no research on penny stocks.

Penny stocks are illiquid. As they trade in low volumes, it’s difficult to sell them. Buyers can be hard to find. Also, the bid-ask spread might be very high.

Another risk factor is their high volatility. There can be big, often inexplicable price swings. As trade volumes are low, even a smaller trade can have a relatively big impact on stock prices. This is also the reason why prices can be so easily manipulated.

Every investor should be aware of the many fraud schemes targeting penny stocks. Fraudsters may start to spread rumours, misinformation or ‘hot tips’ to manipulate the price of a security. They don’t even need boiler rooms and cold calls any more, like Belfort did in ‘The Wolf of Wall Street’. They have a choice of a wide variety of tools, like newsletters, press releases, emails, social media, chat rooms or messaging apps.

Some of the most common fraud schemes

  • ’Pump and dump’ schemes: certain investors try to artificially raise the price of a stock by spreading fake rumours. When the price is high enough, they sell the stock, causing drastic swings in the market. 
  • Basher campaign: fraudsters try to scare investors into selling their stocks and thus drive the price down. 
  • Fake equity research: learn the difference between paid stock promotion that looks like a genuine research note, and equity research by trusted analysts. 
  • Fake information: some fraudsters, for example, may claim that a certain company quoted on the OTCBB is a NASDAQ company, in order to mislead investors. But the OTCBB is not part of the Nasdaq Stock Market, although it is owned and operated by NASDAQ.
  • Don’t get fooled by some fancy name: Think Nikola Corp! Although it isn’t a penny stock, this story offers so many lessons for every investor, including those interested in penny stocks. The company was named after the famous Serbian-American inventor Nikola Tesla, but has nothing to do with either him or car maker Tesla. The company is now under investigation by the SEC over allegations of securities fraud and misleading investors about its business prospects. And remember Belfort’s firm Stratton Oakmont, which was named to sound like an old Wall Street investment company, but was nothing more than a shady boiler room. 

+1 tip

  • Don’t buy the wrong stock! Seriously! This is not a scam, but still. Remember that the SEC in March 2020 had to halt trading in Zoom Technologies after its shares skyrocketed? The main reason was that some investors confused this OTC penny stock with the similarily named NASDAQ-listed video conferencing firm Zoom Video Communications, which became a household name due to the COVID-19 pandemic. When in doubt, check the tickers! Zoom Technologies eventually changed its ticker symbol from the confusing ZOOM to ZTNO, while the ticker of Zoom Video Communications is ZM. 

How to spot a scam?

FINRA offers information, resources and several tools to help protect investors from fraudsters. 

How to spot an investment scam in six steps:

  1. Verify credentials. Don’t fall for a fancy title.
  2. Don’t chase “phantom riches,” that guarantee a certain return or promise big profits.
  3. Ignore the “everyone is doing it” story.
  4. Refuse to be rushed.
  5. Never feel obligated. Don’t invest because the seller gives you something for free.
  6. Arm yourself with information. Learn to spot the red flags of investment fraud.

Source: FINRA 

What makes penny stocks attractive? Rising stars and fallen angels

The idea that they could stumble across the next Netflix or Zoom at an early stage can be very tempting for some investors. The issuers of penny stocks are often small companies at the early stage of their lifecycle with a promising product or service. And some of them do turn out to be success stories. Some even get listed on major stock exchanges later on. While penny stocks have the potential for a big return, so do a lot of small, mid and even large cap companies listed on regular exchanges that satisfy all reporting requirements.

Some investors, in turn, might prefer companies that were once big and strong, but have been delisted from a big exchange for one reason or another. They look for signs that such a firm may emerge stronger again. 

Some investors have only a small amount to trade. As penny stocks are cheap, investors can take a large position with a relatively small amount of money. However, you can buy fractional shares of regular companies at many US brokers, so you don’t necessarily have to buy penny stocks if you only want to spend a couple of bucks at a time. Keep in mind that while a $1 share may be optically cheap, it is the market capitalization and not the share price that tells you the market value of a company. If a $1 penny stock company has, say, 1 million shares outstanding, then the market capitalization is actually the same as a regular company with a $100 share price but only 10,000 shares outstanding.

How to invest in penny stocks?

The first step of investing in penny stocks is similar to investing in any other stock. You have to find a good broker that allows you to trade in the OTC market, and then open a trading account.

Once you have an account, you can start selecting penny stocks in line with your risk sensitivity and financial goals. At this step, penny stock investors should be way more careful than those investing in less risky securities. Remember, penny stocks are not for the faint-hearted! We strongly recommend that you start with demo accounts or stock simulators before putting real money into penny stocks. This way you can better understand the risks and your own risk tolerance.

Do your best to avoid scams. Learn everything you can about the latest and most common fraud schemes. Con artists can be quite creative.
Always do your research and get as much information about your favorite companies as possible.

How to find information about a company:

  • Read corporate reports, if available, and any other disclosures by the company
  • Analyze their balance sheet and income statement
  • Check their website and social media
  • Understand their products and services, as well as their sector and industry trends
  • Check out their competitors
  • Look at the track record of the company’s management to find out everything you can about the executives’ past experience
  • Collect all publicly available information and public disclosure from regulators, commercial databases and research firms
  • Search news sources, like Yahoo Finance, for red flags
Investing in Penny Stocks

Bottom line

Penny stocks are risky and speculative investments. Before you start pouring your money into them, test your risk tolerance, educate yourself, and try trading using a demo account to get the feel of these stocks.

We think that the best approach is to buy the shares of small-cap companies that are listed on a regular stock exchange. These issuers have to meet strict listing and reporting requirements. Invest in a sector you know and trust, where you are an expert or have better-than-average insights. Let’s say you are a doctor, so you may understand the prospects of an up-and-coming health care or biotech company much better than others.

If you still want to invest in penny stocks, keep in mind that they are usually easy to buy and hard to sell. Always check liquidity and trading volumes before you invest, as it might be difficult to enter or exit trades.

Never put all your money in just one or a couple of penny stocks. Always build a diversified portfolio that also includes other, less risky and volatile investments. 

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