Penny Stocks Guide: Everything You Should Know
What you need to know before investing in penny stocks.
Updated 
7 min. read
You could loosely think of penny stocks as the original cryptocurrencies from a risk and return perspective. They are volatile, it can be hard to truly understand what's going on under the hood, there are large communities of investors with no shortage of opinions to share on what to buy and sell, there are extreme risks, and lots of horror stories. If you are going to invest in penny stocks, you need to understand the risks and not just the possible upside.
In this article we will over the following basics about penny stocks:
- What is a penny stock?
- Why are penny stocks risky?
- What is the attraction of penny stocks?
- Penny stock horror stories
- How to manage the risk of penny stock investing?
What is a penny stock?
While there are some technical definitions of what a penny stock is, it's best to think about the general characteristics of what companies would qualify as a penny stock.
- They tend to be very small companies
- The share prices are very low which allows you to buy many shares (and yes could be pennies per share but could also be a few dollars per share)
- They may not be accessible on the traditional, large stock exchanges
- The companies don't tend to be well-known to the general public
- It can be harder to find reliable financial information on penny stocks
- Penny stock shares may have low liquidity and large bid-ask spreads
Penny stocks tend to be very small companies
A penny stock is often defined as a security that trades for under $5 per share. But the share price alone doesn't tell the whole story. You also have to factor in how many shares exist, and then you can get a sense of the market capitalization of the company (the total market value). In the US, penny stocks generally have market capitalizations of under $300 million. They may be referred to as micro-caps ("cap" is short for capitalization), and companies with market capitalizations under $50 million could be considered nano-caps.
Penny stocks allow you buy thousands of shares at a time
Because the share prices can be very low, one of the temptations with penny stocks is the ability to buy lots of shares. For example, if you were buying $1,000 worth of a company with a share price of just $0.10, you would own 10,000 shares. Depending on the day, $1,000 wouldn't even get you one share of Tesla.
Penny stocks don't tend to trade on the bigger, more recognizable stock exchanges
Penny stocks generally are not found on the more recognizable stock exchanges. They can often be found on the OTCBB (over the counter bulletin board), Pink Sheets, and other over-the-counter markets. Your brokerage account may have access to these markets and placing a trade may look almost exactly like placing a trade for any other stock. But note that penny stocks can also be listed on the major exchanges as well - this can often be the case when a company has run into trouble and a previously large company gets devalued into micro-cap territory in terms of value.
Penny stocks are often speculative companies or business ideas
Many penny stock companies may start out as small operations in emerging or trending industries that are not well established, or they may be based on speculative ideas such as hoping to find a new reserve of gold, oil, or other commodities. They could also be trying to develop a new solution to existing problems like finding a new treatment for baldness or heart disease. The common thread in all of these options is that they are speculative. There are low probabilities of achieving what they are setting out to do, but if they do find success the upside could be tremendous to the value of the company. This is perhaps the strongest allure to penny stocks, the possibility of making an enormous gain, however, that possibility doesn’t come without its fair share of risks.
It can be harder to find reliable information on penny stocks
Because a penny stock can be traded without listing on a regulated exchange, they may not be required to file the same level of information about the company's financials or other materially important information. Online forums and communities may also promote and analyze penny stocks but not all information you find online will be sound. Some of it can be merely conjecture and hopeful thinking. And sometimes this environment can foster stock price manipulation in the worst cases.
Penny stock scams and fraud
Penny stocks have long been a ripe target for bad actors to defraud investors of their hard-earned money. It is very important that you are aware and skeptical if you are considering buying penny stocks. You might unwittingly be a victim and chalk it up to a business just not doing as expected. Even if you did find out a company’s stock was part of a fraud scheme, you might not be able to get any restitution.
The movie The Wolf of Wall Street depicts one type of technique used in which promoters would pitch penny stocks to unsuspecting investors using false information to drive the prices up. The promoters would initially buy the shares at low prices but after a few rounds of calls to get other investors drive the prices to artificially high levels trading against themselves, they would then sell their own initial stock at these falsely driven prices. This is known as the "pump and dump" scheme. While these fraudsters used phone calls to promote the stocks, today you can find online communities where a bad-faith promoter might be participating to accomplish the same outcome.
A "short and distort" scam is when someone short sells a stock (betting the stock will go lower) and then spreads deliberately false information about the company to drive the price lower. They then cover their short sales at the lower price resulting in a profit.
One of the biggest scams in history involved the mining company Bre-X. They told investors that they had discovered an enormous reserve of gold on property they owned and the stock, which was a penny stock, increased to a (split-adjusted) value of $286.50 per share giving the company a value of over $6 billion. The claim of the gold reserve was later found to be fabricated and the company went bankrupt.
How to manage the risks of investing in penny stocks
It's important to remember some of the core tenets of portfolio management, especially when you have exposure to single stocks that are highly speculative. Many investors never invest in penny stocks and you don't have to either to be a successful investor
But if you are investing in penny stocks, here are a few considerations:
- You can diversify amongst different penny stocks to reduce your single security concentration risk. Many penny stocks lose significant amounts of value. By spreading out your eggs into different baskets, you reduce this risk.
- The total proportion of your investment portfolio made up of highly speculative investments can be limited. Just as some experts recommend allocating no more than set percentage (for example 5% or 10%) to cryptocurrencies or gold, you could consider the same guideline if you decide to invest in penny stocks. To be even more conservative, you could consider that the total allocation to any of those asset classes combined should remain within the 5% to 10% range of your overall portfolio.
Of course, there are some investors who will predominantly hold highly speculative investments. Remember that the probabilities of extreme losses are high and that you could lose the majority of the money you have invested. Even the occasional win, when calculated against the many potential losses, might not perform as well over the long term as a globally diversified portfolio of traditional stocks and bonds. Make sure to do your research and go in with your eyes open.
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