Education • 5 min read
By Camilla Marziani
Even though the name might suggest differently, penny stocks aren’t stocks selling for a penny - still, they’re rather inexpensive, selling at much lower prices than other stocks. While it may be tempting to buy cheap stocks and hope for high gains, penny stocks are considered risky investments and often linked to scams, such as pump and dump schemes.
Let’s take a look at what penny stocks are and why investors are divided between trying their luck with them or staying as far away as possible.
Just like traditional stocks, penny stocks represent shares in a company that investors can buy, therefore participating in a company’s income and increasing the value of the stock. While the name “penny stocks” might suggest an even lower trading price, penny stocks are defined as stocks of public companies that are generally trading for less than $5 a share.
One of the main differences between penny stocks and more “traditional” stocks is their price range: while the prices of more traditional stocks can vary widely, penny stocks’ prices are by definition limited to a maximum amount, usually considered $5 - as defined by the U.S. Securities and Exchange Commission (SEC).
Penny stocks are known as a high risk, all-or-nothing type of investment. While some investors may feel tempted by the low prices and the - remote - chance of very profitable gains in the event the price does go up, investors need to be highly aware of losses due to scams and high volatility.
Unlike shares of blue-chip companies, a much smaller proportion of penny stocks is listed on major exchanges, simply because they usually don’t fulfil the requirements for a listing in terms of market cap and other criteria. For instance, companies looking to be listed on the New York Stock Exchange (NYSE) need to have at least 1.1M equity shares, with a total value starting from $100M, with a minimum share price of no lower than $4 per share.
There are a few penny stocks that make it to exchanges such as the NYSE. Many times, the companies behind penny stocks are small, not very well-established or thriving in terms of market capitalisation and liquidity, which are highly-relevant factors when it comes to being listed. The companies behind penny stocks simply can’t prove they will grow or even that they’ll be around for long enough to be considered by major exchanges.
The fact that major stock exchanges don’t list penny stocks proves to be disincentivising for many investors. Even though reputable exchanges such as the NYSE and the NASDAQ happen to sometimes list penny stocks, most of them are offered to investors “OTC”, “over the counter”.
This means they’re not traded in a centralised exchange, but through broker-dealer networks instead. The most famous ones for OTC penny stocks are the OTC Bulletin Board (OTCBB) and the OTC Markets Group.
Pink sheet stocks also fall under the umbrella of OTC stocks. The name “pink sheet” comes from the colour of the sheet of paper used to publish these types of stocks, before trading went digital. Pink sheet stocks are also traded over the counter but one main factor distinguishes them from OTC penny stocks. Very rarely even reputable companies trade on the pink sheet market, but most of the time, pink sheet stocks are also penny stocks. The main difference between penny stocks and pink sheet stocks is that, while penny stocks are required to be under $5, pink sheet stocks can be listed for a higher value.
A crucial factor that renders OTC penny stocks (but also pink sheet and over-the -counter stocks in general) high-risk investments is their illiquidity - the potential to become unsellable. Trading over the counter means that investors can find themselves in the unfortunate situation of wanting to sell their shares but not being able to find buyers at the time or finding a buyer for the price they set.
Hence, there are some significant risks associated with investing in penny stocks - and if you’ve watched the blockbuster movie “The Wolf of Wall Street”, you may already have an idea what we’re talking about.
One major risk for investors who invest in Penny Stocks is to fall prey to scams. This is because, as of today, companies don’t necessarily need to complete due diligence and to fulfil set requirements or share their financial information to get penny stocks listed OTC or in the pink sheet market. Unsurprisingly, a common scam consists of shell companies listing penny stocks over the counter to trick investors into buying cheap - and worthless - stocks.
Other scams associated with penny stocks have to do with malicious and offshore companies and sketchy requirements on the buyers. For instance, sellers requiring buyers of penny stocks to not sell for a while, a “guru” offering “life-changing financial advice” if you buy their shares, and similar conditions. But the most famous - and infamous - type of scam that investors could fall prey to when trading penny stocks, OTC and pink sheet stocks is a pump and dump scheme.
In the case of a pump and dump, malevolent individuals promote shares of an unknown company, painting it as a fantastic and profitable investment, and trying to get investors to buy shares of said company. This way, investors falling prey to this offer become new shareholders and buy in, “pumping up” the price of the shares. Once the price is deemed high enough for the people orchestrating the scam, they sell their shares - the dump part of the scam - and leave investors with worthless stocks.
These and many other scams periodically make the headlines for the damage done to investors. To avoid scams when you are investing in any asset, it’s always best to learn the basics of investing and to gather information from reputable sources before you make any investment decision.
If you’d like to start investing, either in fractional stocks* or other digital assets, Bitpanda is the right place for you. On Bitpanda, you can invest in more than 1,000 assets - from cryptocurrencies and precious metals to fractional stocks* and ETFs* with Bitpanda Stocks*, all with tight spreads, no commission, 24/7, and even automatically via Bitpanda savings plans.
*This blog article is not intended to be used as a general guide to investing and should not be seen as investment advice. Bitpanda Stocks enables investing in fractional stocks. Fractional stocks in Europe are always enabled via a contract which replicates the underlying stock or ETF (financial instruments pursuant to section 1 item 7 lit. d WAG 2018). Investing in stocks and ETFs carries risks. For more details see the prospectus at bitpanda.com.
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