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What Are Penny Stocks & How Do They Work?

By Michael Flannelly · July 01, 2022 · 5 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What Are Penny Stocks & How Do They Work?

Penny stocks are shares of small companies that trade for less than $5 per share. They are highly speculative investments, meaning they carry a high degree of risk. Usually, traders looking for short-term gains use penny stocks, rather than long-term investors looking to build wealth.

But investors are often allured by penny stocks because they are relatively cheap and offer potentially high returns. Most people have a story of a relative who swears they know about a great penny stock that’ll cost next to nothing, promising some way to get rich quickly. While this story is seductive, it’s far from reality. Before trying to use penny stocks to make quick gains, investors must know how they work and the risks involved.

What Are Penny Stocks?

Penny stocks are low-priced securities that trade for less than $5 a share, though usually, they trade for less than $1.

Penny stocks are generally considered to be highly speculative and risky investments. This is because most penny stocks are issued by small, unknown companies with little or no operating history. In addition, these companies often lack the financial resources to continue operating for very long and are susceptible to fraud.

​​Despite the risks, some investors are attracted to penny stocks because they offer the potential for large profits in a short period of time. For example, if a penny stock’s price doubles from $0.30 per share to $0.60 per share, that’s a 100% return on investment on just a $0.30 price increase. Of course, the flip side is that you could also lose all of your investment just as quickly.

Exploring Penny Stocks & How They Work

Although some penny stocks trade on major exchanges, such as the New York Stock Exchange or Nasdaq, most penny stocks trade on the over-the-counter (OTC) market, through the OTC Bulletin Board (OTCBB) or on the pink sheets.

Penny stocks that trade on the OTC market do not have the same regulatory requirements as companies listed on major exchanges. Companies that list their shares on the major exchanges are subject to a high degree of regulatory scrutiny; these publicly traded companies must meet minimum listing standards and provide regular financial reports to the Securities and Exchange Commission (SEC).

In contrast, over-the-counter stocks have fewer hoops to jump through, as they do not have to meet minimum listing requirements. However, penny stocks that trade on the OTCBB must file financial statements with the SEC, while penny stocks listed on the pink sheet are not required to do so.

Because many penny stocks do not have to report periodic financial statements to a regulatory agency, it can be difficult for investors to find adequate information to make informed investment decisions on these securities. This lack of knowledge is one of the reasons penny stocks are risky investments.

Penny Stocks Are Highly Speculative

As noted above, penny stocks are highly speculative investments often bought and sold by traders who want to make short-term gains. Because of this potential for significant, short-term gains, many people view penny stocks as a way to get rich quickly. However, this is far from the case; penny stocks carry a high degree of risk and, as such, should be traded by people with the time, money, and risk tolerance to dabble in this market. You should only invest in them if you are willing to lose all of your money.

💡 Recommended: The Difference Between Speculation vs. Investing

Who Can Buy Penny Stocks?

Anyone can buy and sell penny stocks, though it is recommended that they have the appropriate risk tolerance before investing in these speculative securities.

To trade penny stocks, you’ll need to open an account with a broker that offers OTC trading. Many online brokers offer this service, but do your research before selecting one, including what kind of fees they charge. Once you have an account, you can start buying and selling penny stocks. Just remember to be careful, as they can be very risky.

Pros of Penny Stocks

High Reward Potential

There is a belief by some penny stock traders that these small securities have more room to grow than large stocks, thus resulting in significant, short-term price appreciation. The potential for short-term gains means that penny stocks may provide high rewards, despite their risks, especially if traders utilize buying on margin to make their trades.

Enjoyment

Just as some people like to gamble, others like to trade stocks and other securities for fun. Plenty of people would consider analyzing stock charts, reading up on unknown companies, and making bets as one of their hobbies. Traders like this might consider penny stocks as “fun spending,” not long-term investing.

Cons of Penny Stocks

Small Likelihood of Success

Making money on a penny stock can be a rare occurrence. Investors should be aware of this, despite the tales of sudden wealth they may hear. Also, contrary to popular belief, success by investing in penny stocks can often take a long time.

Possibility of Losing it All

A small likelihood of success means that there will inevitably be many failures. It is common for small, unestablished businesses to fold and go under, flounder, or have unsuccessful stock. When stocks become worthless, investors lose all of their money.

Lack of Liquidity

Penny stocks usually do not have a lot of liquidity, meaning it can be challenging to find buyers when you want to sell. This can make it hard to get out of a position if the stock price declines.

Volatility

Penny stocks have high volatility, which means that their prices can change a lot, rapidly. This can happen in either direction, making them a difficult tool for building long-term wealth.

Scammers

The penny stock business is ripe with scammers and fraudsters. Numerous penny stock newsletters promise big wins, and penny stock “investors” manipulate both the market and potential customers.

Researching Penny Stocks to Buy

It’s often difficult for investors to adequately research what penny stocks to buy and sell. Because many penny stock companies do not have to file reports to regulators, investors do not always have great information about the company’s finances, management, and operations.

One of the first things investors should do is check websites like the OTC Markets website to search for company information on the penny stocks you’re interested in. Once you’ve done that, you can see if the companies have filed reports with the SEC through its EDGAR database . Using this company and financial information, you can develop a sense of the company’s finances and business practices.

Also, it may help to look at penny stocks that trade on exchanges such as the NYSE or NASDAQ. Because these stocks are required to file regular financial reports to the SEC, there is more easily accessible research investors can use to make investment decisions. Additionally, these companies are usually more stable and have more liquidity than penny stocks trading on the pink sheets or OTCBB.

Overall, you want as much public information as possible when researching penny stocks to buy and sell. When you make investment decisions with inadequate public information, you may open yourself up to relying on shady information that could come from paid promoters or fraudsters looking to pump and dump a stock.

The Takeaway

The allure of making significant, short-term gains by trading penny stocks draws many people into this market. But with the potential of high rewards comes the increased risk and a probability that gains will be hard to come by. Before diving into penny stock trading, assessing your risk tolerance is essential to see if this strategy is right for you.

For investors more comfortable with trading penny stocks listed on the major exchanges, like NYSE and Nasdaq, SoFi can help. With SoFi Active Investing, investors can buy and sell stocks, as well as fractional shares, exchange-traded funds (ETFs), and crypto, with no commission for as little as $5.

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FAQ

Can you make money with penny stocks?

While making money with penny stocks is possible, it is also possible to lose money. Penny stocks are generally considered a high-risk investment, and as such, they may not be suitable for all investors.

Are penny stocks good for beginners?

Penny stocks are generally not good for beginners. They are often very volatile and can be challenging to trade.

Are penny stocks popular investments?

Penny stocks are sometimes popular investments for traders looking for high-risk, high-reward investments. These stocks are typically very volatile, which can lead to significant profits or losses.


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