What Are Penny Stocks?

Written By Duncan Ryan
Last updated August 25, 2021

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August 25, 2021

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Many new investors find themselves asking the question “What are penny stocks?” after seeing the phrase mentioned online. Here’s what you need to know about penny stocks and how they work as an investor.

Penny stocks are shares of small companies that trade for under $5 per share. Typically, these stocks trade at fairly low volumes on an over-the-counter basis. Some, however, trade through the NYSE or the NASDAQ. The companies issuing penny stocks tend to be relatively new and unestablished, accounting for their low share price.

For fledgling companies, penny stocks represent a way to raise early funding and get their ideas off the ground. Often, the companies are raising funding for projects that haven’t yet begun or are in their very early stages. While investors can buy penny stocks to own shares of projects they believe in, they are more often used for speculation.

Four Tiers

Traders often categorize penny stocks into four tiers according to price and risk level. Tier one stocks trade for under $5 on major exchanges and are legitimate companies. Then, tier two stocks trade for $0.01 or more and may be listed on a major exchange. Tier three stocks cost less than a penny, trade over the counter, and are highly speculative. And, tier four stocks trade for tiny fractions of a penny and are extremely risky. Generally, only tier 1 and some tier 2 penny stocks are even worth considering as investments.

Now that we’ve answered the question of “what are penny stocks,” let’s take a look at their benefits. The main advantage of penny stocks is their potential to produce gains that significantly beat the overall market. Thanks to their low price, investors can buy large numbers of shares and profit from comparatively small price fluctuations. Suppose, for example, you held 5,000 shares of a stock valued at $1.50. An increase in price to $2 would yield a 33 percent return and a profit of $2,500.

Fast Returns

In addition to the size of the potential gains, penny stocks also offer relatively fast returns. Few investors choose to hold penny stocks for years or decades like traditional growth stocks. Large price moves often occur over a period of days to weeks, allowing investors to capitalize on their investments quickly.

Finally, there’s the potential to find a future success story in its early stages. A tiny minority of penny stock firms eventually become successful, mainstream companies. Investors who get in early and hold their positions can reap large gains when this occurs. This introduces even larger potential gains and an element of thrill to investing in penny stocks. You should understand, however, that such companies are extremely rare and your chances of successfully identifying one are remote.

The potentially high upside of penny stocks comes with proportionately high levels of risk. While small fluctuations in the prices of inexpensive stocks can outpace the overall stock market, they can also produce outsized losses. A $2 stock that drops to $1, for example, would produce a 50 percent loss with a relatively small price move. If you prefer more conservative strategies like buying index funds or investing in mutual funds, penny stocks are likely beyond your personal risk tolerance.

Losing Investment

Because penny stock companies are small and generally unproven, it’s not unusual for them to simply go out of business. For this reason, you should be comfortable with the possibility of losing your entire investment when investing in penny stocks.

In addition to their inherent volatility, penny stocks usually have low liquidity. This means it may be difficult for you to sell your shares when you’re ready. To address this problem, it’s best to choose the subset of penny stocks that trade on major exchanges. Exchange-traded stocks almost always trade at much higher volumes than those traded over the counter.

For all but the most risk-tolerant investors, penny stocks present too much risk to be considered seriously as investments. There are, however, penny stock alternatives that offer some of their upsides without as much risk.

The low cost of buying penny stocks is one of their largest appeals to new investors. If you’re trying to invest on a tight budget, spending $50 or more on larger stocks can seem intimidating. With fractional shares, though, you can invest in large companies for as little as $1. Fractional shares are small pieces of larger stocks. With them, you can buy holdings in blue-chip companies without spending hundreds or thousands of dollars.

Higher Risk Higher Reward

If you’re looking to take on a bit higher risk for more potential reward, you have several options beyond penny stocks. Stocks in the $5-10 range allow a bit of room for speculation without the outsized risks of true penny stocks. Traditional stocks with high beta ratings, a measure of volatility compared to the market, are also good alternatives. These stocks usually produce outsized returns in bull markets but have higher risk in bear markets. The combination allows investors to profit from volatility without quite as much risk as penny stocks.

Investments outside of stocks can also help you chase higher returns in exchange for higher risk. Peer-to-peer lending, for instance, offers a high upside in exchange for the risk of default. High-yield bonds offer a similar proposition for investment-grade corporate debt. Cryptocurrency famously produces high yields but comes with more volatility than stocks.

What are penny stocks, and how do they work? Now that you know the answers to these questions, you can make a more informed decision about including them in your portfolio. While penny stocks are too risky for most investors, very risk-tolerant traders may want to consider using them to reap large, short-term gains. Be sure to carefully evaluate your own risk tolerance and only invest money you can completely afford to lose when dealing with penny stocks.

About the Author

Duncan Ryan

Duncan Ryan is a long-time professional freelance writer with a focus on finance, economics, science, technology and medicine. A lifelong independent learner, Duncan is always on the search for the next exciting challenge.

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