What Are Penny Stocks?

Penny stocks are high-risk, high-reward securities with a small market capitalization that trade at a low share price, generally outside the major market exchanges. Because of their intrinsic low volume, they tend to be more volatile than other well-established equities. They offer opportunities for profits or losses depending on your investment strategy.

If you're looking to break into a new market, trading penny stocks is one way to diversify your portfolio and fire up your investment. These companies provide growth potential and can deliver extraordinary profits if held for an extended period and the company does well. Owning stocks of companies that later developed into large-cap, well-established equities have allowed investors to multiply their fortunes on numerous occasions. Nonetheless, there are risks associated with trading these stocks.

If you do due diligence and adopt an appropriate strategy, the possible gains might outweigh the related risks. Before diving into the world of penny stocks, it's vital to master the fundamental characteristics of these low-priced securities to determine if they're suited for you.

Benzinga takes a deep dive into penny stocks to help you understand what they are, the associated risks and benefits and how they work.

Penny Stocks Defined

Penny stocks are securities issued by small companies that trade for $5 or less. Corporations with smaller market capitalizations typically issue these securities. Therefore, depending on the company's market capitalization, they are also known as nano-cap stocks and micro-cap stocks.

A penny stock is defined by the U.S. Securities and Exchange Commission (SEC) as securities issued by a small-cap or micro-cap company with a market cap of less than $250 million. The SEC is an independent federal government body tasked with protecting investors by ensuring the proper and orderly operation of the securities markets. The commission's guidelines also refer to shares issued by small companies trading under $5 — company stocks under $5 — as penny stocks.

Penny stocks typically trade outside major exchanges like the New York Stock Exchange (NYSE) or the Nasdaq exchange. Although some still trade on these exchanges, most trade in the over-the-counter market via the OTC Markets Group or pink sheets. To maximize profit from these low-priced equities, investors often buy many shares of it in the hope that the price will rise.

Penny stocks usually represent developing companies with limited funds and resources. Since they are primarily small-cap shares with low volume and liquidity, penny stocks are most suitable for investors who have a high tolerance for risk and are good at sniffing out penny stock scams. Its relatively high volatility compared to large-cap stocks means a higher potential for reward. However, it is essential to note that while penny stocks can have explosive gains, they are high-risk investments with low trading volumes. It is vital to have realistic expectations when trading penny stocks.

Why Invest in Penny Stocks?

Penny stocks can be an excellent way to diversify your portfolio and grow your wealth. Here is a look at why you may consider investing in penny stocks.

Significant Growth Potential

Like the early days of some of today's mega-corporations, potential great companies may be trading at pennies on the dollar today. These companies may be led by highly efficient executive teams, have strong financial standing and offer innovative products or services positioned to dominate their industrial sectors. These attributes are vital ingredients for long-term growth and market domination. Amazon.com Inc. (NASDAQ: AMZN) is an example of one such case where a company started as a penny stock entity but subsequently developed into a large blue-chip corporation.

Because of its lack of liquidity, institutional investors cannot profit as much as retail investors from penny stocks. In some ways, this opens the door for retail traders to earn significant returns. So making penny stock part of your portfolio can help you maximize return on investment (ROI). With the right investment strategy, penny stocks can potentially outperform large- and mid-cap funds. Nevertheless, it would be best if you exercised due diligence, as not all penny stocks have the potential to grow into blue-chip winners.

Low Share Price

The low share price of penny stocks is one of their most appealing characteristics. Unlike large-cap companies, they're readily available to traders with varying account sizes, including those on a budget. For instance, a share of Warren Buffett's Berkshire Hathaway Inc. Class A (NYSE: BRK-A) costs over $400,000. Most investors worldwide cannot afford one share of this stock. They can, however, readily afford thousands of penny stocks with just 1% of the same capital.

Additionally, because penny stocks are relatively cheap, you can buy them without risking a substantial percentage of your investment funds. Investing a portion of your portfolio in penny stocks could diversify your portfolio and offer you the opportunity to potentially earn a windfall.

High-Profit Margins

Penny stocks have the potential for explosive growth. Typically, companies that provide them are still in the early stages of development. This suggests that the stock's value can potentially climb faster than the high-priced equities of major, well-established firms.

Because of their low pricing, penny stock investors may easily purchase thousands of them. With that scale, a few pennies per share gain could translate into significant percentage profits. Suppose you buy 10,000 shares of XYZ company penny stock, at $0.01 each, for a total investment of $100. If the stock goes up by just 20 cents, your total investment will now be $2,000 (0.2 x 10,000) — a 2,000% ROI from a single trade.

Short-Term Volatility

With penny stocks, you can potentially earn ROI when the value of the stock changes from volatility. For instance, while the conventional approach is to go long, you can short-sell penny stock when it starts declining or you believe the share price will tumble and the company will fail at some point. Short-term day and swing traders can reap benefits from penny stocks because of their significantly higher volatility compared to large-cap stocks.

Easy Entry

One of the most significant advantages of penny stock trading is the low entry-level bar. It is easy to get started. There are no special qualifications or degrees required. A laptop, an internet connection and a brokerage account are all you need. From creating a brokerage account to purchasing stocks, there is little technical knowledge required to complete the setup for trading penny stocks.

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Risks When Investing in Penny Stocks

While the benefits of investing in penny stocks are numerous, the risks are equally huge. In fact, penny stocks are even riskier than regular stocks. Here is a look into some of the significant risks associated with trading these stocks.

High Risk

Trading penny stocks is a high-risk investment strategy. Small companies are the most prone to bankruptcy in times of financial difficulty. Instances in which investors have lost all their initial capital are not uncommon with penny stocks. A penny stock has a real chance of losing its value or being delisted because of its young age and short tenure on the stock market. Before trading penny stocks, it is imperative to have a solid risk management strategy in place.

Low Liquidity

Penny stocks inherently have low liquidity — they don't have high trading volumes because of their small size(market capitalization). When a stock has low liquidity, you won't be able to sell the stock quickly. Because of the limited liquidity, finding a buyer for the stock might be a hassle, and you may have to lower your price to match another buyer's bottom line.

Low liquidity also opens up the opportunity for stock price manipulation. There are many ways bad actors can achieve this, the most common being the pump-and-dump technique. Here, the trader buys large amounts of stock, hypes it up and then sells it after other investors have driven up the price.

Lack of information

Acquiring substantial knowledge to make informed judgments is fundamental to every successful investment strategy. Unfortunately, there is an information risk inherent to penny stocks. The SEC doesn't mandate financial reports and filings for companies listed on pink sheets. Therefore they are not subject to the same public scrutiny or regulation as the stocks traded on significant stock exchanges such as the NYSE and Nasdaq.

Since these companies aren't obliged to provide their financial information to the public, accurate information about them is lacking. Trading stocks based on limited available data can be disastrous.

Little History

Many penny stock companies are typically micro-cap stock entities either recently established or on their way out of business. Often, these companies don't have excellent or comprehensive track records. The typical penny stock company has a terrible track record or none.

While a security's historical performance might not be an indicator of future performance, it can be a good gauge of its inherent potential. As you can imagine, in the case of penny stocks, the lack of historical information makes it difficult to determine their potential.

This factor makes investing in them highly speculative. Trading in such a speculative manner without appropriate data points is extremely risky. The risk is especially high for non-traditional investors such as short-term and seasonal traders who require comprehensive price performance data to trade profitably.

Exercise Caution with Investment Decisions

Penny stocks offer risks and benefits for investors. They provide the potential for significant gains and easy entry and diversification. However, they also come with high risk, including the possibility of losing all initial capital. Investors must exercise caution and conduct thorough research when considering penny stock investments.

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Benzinga analyzes, reviews and provides valuable insights on penny stocks and individual stocks of large-cap companies, including technology, insurance, finance, cannabis and virtual payment platforms.

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