What Are Penny Stocks? An Investor’s Guide

Key Takeaways:


The stock market comprises equities that range from tens of thousands of dollars to fractions of a single dollar. Not surprisingly, their valuations are directly correlated to performance; the more potential a public company has, the higher the share price. However, it is worth noting that there’s an entire marketplace that flies under the radar and refuses to conform to conventional wisdom: the Over The Counter (OTC) Market.

The OTC market consists of securities that have been dubbed penny stocks and don’t yet meet the requirements to trade on today’s major exchanges. Nonetheless, many investors have found these securities to be a valuable addition to their portfolios, which begs the question: what are penny stocks?

The following is intended to identify what these securities are and help new investors navigate the risk that has become synonymous with these securities.

What Are Penny Stocks?

Penny stocks are exactly what every investor would assume: equities that trade for mere pennies on Wall Street. More specifically, however, they tend to trade for somewhere in the neighborhood of 500 pennies ($5.00) or less per share. That’s not to say there’s a definitive price point that defines a penny stock, but rather that they have developed a reputation for trading around $5.00 or less. As a result, penny stocks have become synonymous with several monikers that suggest lower valuations: microcaps, small caps, stocks under $5, and more.

Equally as important as penny stocks themselves is where they are traded. Penny stocks that meet the minimum requirements can be bought and sold on the secondary market under major indices. Consequently, those which haven’t met the requirements are relegated to what’s known as the Over The Counter market. Overseen by the Financial Industry Regulatory Authority, OTC markets require the securities listed on them to meet minimum standards (which are inherently less strict than today’s major indices). As a result, low-valued securities have become notorious for providing less information than their bigger stock market counterparts. The void of information does pose a risk to investors, but the lack of credible data may also harbor several equities with a lot of potential.

Despite trading for $5.00 or less, there’s a wide range of penny stocks for investors to consider. In fact, the quality of these securities can be broken down into tiers, not the least of which are outlined below.

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How to buy penny stocks

Tier 1

The highest grade given to penny stocks, tier one, suggests they have met the minimum requirements to trade on today’s major exchanges. According to Investopedia, “The requirements typically measure the size and market share of the security to be listed, and the underlying financial viability of the issuing firm.  Exchanges establish these standards as a means of maintaining their own reputation and visibility.” In other words, tier one securities trade for $5.00 or less and have already been approved by today’s largest indices. As a result, investors can expect to see more transparency than securities listed on subsequent tiers.

Tier 2

Most major exchanges require securities to trade for more than a dollar for a predetermined amount of time. Tier one, for example, has already met this requirement. Tier two, on the other hand, are securities that trade for less than a dollar or have yet to meet the minimum requirements of being traded on large exchanges. That’s not to say tier two securities can’t join their tier one counterparts, but rather that they have yet to do so. As a result, tier two is generally less transparent and riskier than tier one.

Tier 3

Even less transparent and more of a risk to investors, tier three tends to trade for less than a penny. Otherwise known as sub-penny stocks, tier three hasn’t proven enough to be moved up to tier two and is currently being held back by their lack of transparency and experience. For context, tier three securities have many obstacles to overcome before they may even be considered part of tier one.

Tier 4

Yet another rung down on the ladder, tier four is even less transparent than those in tier three. As a result, stocks in this category have been dubbed “triple zero stock,” which refers to share prices between 0.0001 and 0.0009 cents per share.

Benefits And Disadvantages Of Investing In Penny Stocks

Penny stocks have developed a divisive reputation, and rightfully so. If for nothing else, they are the epitome of high-risk/high-reward investments. While the lack of transparency prevents many investors from conducting the appropriate amount of due diligence to evaluate a stock properly, the valuation rewards investors with almost unlimited potential. Outside of the risk/reward profile, however, there are subsequent pros and cons investors must consider before they invest in these types of securities.

Advantages Of Penny Stocks

The advantages of penny stocks include, but are not limited to:

  • Accessible: While not all brokerages allow investors to buy and sell penny stocks on OTC markets, the vast majority of today’s most trusted brokerages do. Of course, there are a few exceptions, but most investors who already have a brokerage account can buy and sell penny securities as they please. That said, investors trading on OTC markets can expect to incur a small fee from their brokerage.

  • Affordable: Aptly named, penny stocks are incredibly affordable. As we have already discussed, some can trade for fractions of a penny, making the barrier to entry incredibly low. It is worth noting, however, that penny stocks are affordable for a reason. While they may be cheap, they do carry a lot of risk.

  • Potential: Given the incredibly low valuations assigned to most OTC securities, promising companies trading for fractions of a penny can represent significant potential. At the very least, most are in the very early stages of business, which means those that pan out can increase almost exponentially and still fit within a reasonable market cap.

  • Liquid: Not unlike traditional equities and securities, penny stocks are highly liquid. Any investor who needs access to cash needs to sell their shares. While the amount of time the transaction takes will vary from broker to broker, investors often have access to cash immediately.

Disadvantages Of Penny Stocks

The disadvantages of penny stocks include, but are not limited to:

  • Risky: There’s no equity or security that carries greater risk than penny stocks. Due, in large part, to the lack of financial information and data on each company, investors are essentially working in the dark. Without access to the information they need, investors are essentially investing blindly, which poses a significant risk. Many investors wait for the securities to reach tier one before they even consider investing.

  • Low Quality: Most penny stocks are penny stocks for a reason; they don’t have the track record or credentials to be anything more. As a result, most are considered to be low-quality investments. The likelihood of a penny stock panning out is lower than their higher-valued counterparts traded on major exchanges. That’s not to say all penny stocks aren’t representative of quality companies, but rather that the good ones are few and far between.

  • Brokerage Fees: Most brokerages will charge an additional fee for buying and selling penny stocks over the counter. The added fee can eat into profit margins and make a tough situation even tougher.

  • Scams: Since most penny stocks aren’t required to report their financials, there’s a higher likelihood of lies, scams, and pump and dumps.

How To Buy Penny Stocks

Learning how to buy penny stocks will vary from investor to investor, but the following steps outline one of the easiest ways to get started:

  1. Determine Your Approach & Goals: Before even looking at a single penny stock, aspiring investors need to determine what they want to accomplish in OTC markets. In particular, investors should determine what they want to get out of investing and how these securities can help them get there.

  2. Come Up With A Budget: Investors need to formulate a budget before they invest in any equities or securities; that way, they will be able to manage their personal finances simultaneously and budget individual contributions moving forward. With that in mind, investors shouldn’t invest money they will need soon.

  3. Sign Up With A Brokerage: Investing in penny stocks requires a brokerage that deals in OTC markets. Therefore, investors will need to make sure they open an account with a qualified brokerage. Once they are signed up, buying penny stocks is as simple as minding due diligence and picking the socks that meet the investor’s criteria.

  4. Choose The Best Penny Stocks To Buy: The best securities, or those that represent the lead amount of risk, are few and far between. Remember, penny stocks are cheap for a reason: they are unproven. Still, there are a few winners that can rise to the top. Investors need to research the companies and invest in the stocks that give them the best chances of realizing a breakout.

  5. Invest With A Long Time Horizon: OTC securities often represent equity in very small businesses. As a result, investors will need to exercise patience as they build out their positions. It could take years, if not decades, for a penny stock to become a true winner. At the very least, learning how to know when to buy and sell penny stocks is extremely difficult. Instead, investors should play the long game.

Summary

Penny stocks have developed a reputation as risky investments. Their lack of transparency and inherent connection to unproven, upstart businesses expose shareholders to more risk than their exchange-listed counterparts. Still, the allure of investing in a company that’s just getting started or buying thousands of shares for next to nothing can be an attractive proposition. Again, penny stocks are the ultimate high-risk/high-reward investment, and investors should treat them accordingly. That’s not to say penny stocks don’t belong in a diversified portfolio, only that the risk they pose must be accounted for.


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FortuneBuilders is not registered as a securities broker-dealer or an investment adviser with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority (“FINRA”), or any state securities regulatory authority. The information presented is not intended to be used as the sole basis of any investment decisions, nor should it be construed as advice designed to meet the investment needs of any particular investor. Nothing provided shall constitute financial, tax, legal, or accounting advice or individually tailored investment advice. This information is for educational purposes only is not meant to be a solicitation or recommendation to buy, sell, or hold any securities mentioned.

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