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Why Do Penny Stocks Exist?

Aria Thomas

Jul 29, 2022 14:10

Compared to stocks of well-known corporations, penny stocks may seem inexpensive. Penny stocks might be an excellent method for earning money rapidly. However, they are also a perfect way to quickly lose a lot of money. Penny stocks have always seemed hostile to the ordinary risk-averse investor, but investors with a high-risk tolerance are nevertheless eager to try their luck with these stocks. Why do they exist since most brokers advise you to avoid pink sheets and OTC shares?

What are penny stocks?

Penny stocks are low-priced, high-risk assets having a limited market capitalization. They are often traded outside of major exchanges, are relatively inexpensive to invest in, and frequently have a little history. Penny stocks are stocks that trade for less than $5 a share, according to the Securities and Exchange Commission. Typically, these shares are issued by tiny, emerging companies with modest market capitalizations to stimulate growth.

However, outliers do exist; Penny stocks are seldom seen on large stock exchanges such as the NYSE and NASDAQ. They are often traded over the counter through a broker-dealer network as opposed to a controlled exchange.

The majority of penny stocks trade on the OTC Bulletin Board (OTCBB) or OTC Markets Group. The OTCBB has a set of conditions that firms must complete before they may be listed; however, they are far less stringent than the SEC's requirements for listing on a major exchange.

Pink sheet firms should also be mentioned; these stocks are sold over the counter, but unlike the OTCBB, there are no listing restrictions. If this sounds like a red (or maybe pink) flag to you, that's excellent. Pink sheet stocks are exceedingly hazardous, yet a significant number of genuine firms opt to sell their stock in this manner.

Investing in penny stocks is particularly accessible due to their low price, and even slight changes in the company's price may result in massive gains that dwarf the usual stock market returns. These stocks do not, however, have lengthy track histories or nearly as much transparency as traditional stocks.

Volatility is the one characteristic that identifies penny stocks. This volatility may be an excellent opportunity for investors, but it also brings with it a tremendous deal of risk. With penny stocks, price fluctuations are magnified, and just as a slight gain might result in large stock, a small decline can result in a significant loss.

What sets penny stocks apart?

Penny stocks are a distinct category of investments. They are quite inexpensive, making them accessible to nearly any trader who wants to give them a try. If any investment can be classified as high-risk and high-reward, are they Penny stocks? They are very volatile on average, with little price fluctuations resulting in enormous percentage profits or losses.

The listing criteria for penny stocks need far less detailed financial reporting. This implies that it is far more difficult to adequately investigate stocks such as these, and even if you bring up all the probable relevant facts, you’re still likely dealing with considerably less information than conventional stocks.

Penny stocks can see rapid price fluctuations since buyers may acquire a large number of shares at once. Penny stocks are similarly prone to rapid price fluctuations owing to the news.

This may lead you to feel that penny stocks and day trading are a perfect fit. However, you should only combine this volatile asset class with a dangerous form of investing if you are entirely convinced that you can maintain ultimate discipline.

The low amount of liquidity that is typically seen in penny stocks frequently leads to huge bid-ask spreads and might create issues when it comes time to sell your investments, hence increasing the riskiness of these already volatile stocks.

Lastly, one characteristic that distinguishes penny stocks from other investments is the potential for significant returns. Triple-digit gains are far more typical with penny stocks than with ordinary stocks.

How do penny stocks operate?

Trading penny stocks differs significantly from trading on big exchanges. Most Wall Street trading methods are predicated on playing the long game or seeking out tiny firms set for rapid growth. However, penny stock trading is most effective when you concentrate on a short-term investment that enables you to enter and exit the market rapidly.

Ideally, investing in penny stocks works best when you spot a good market trend, buy shares fast, and then sell penny stocks before their value drops again. Penny stocks are considered risky investments in part because their trading tactics are virtually exclusively short-term.

Since these marketplaces are not carefully regulated, fraud is the main worry concerning OTC penny stocks. Although uncommon, penny stock firms may be the consequence of marketing initiatives aimed to complement pump-and-dump operations.

Others are little businesses with little to no worth that may have just opened their doors. These companies have no history and few stock transactions from which to get information. Sadly, the majority of these businesses never achieve success and finally collapse.

Les actions priced at less than $5 a trade seem to be an excellent entry point for novice shares. However, the aforesaid considerations make the penny stock market hazardous for beginners. Nonetheless, diligent traders who can monitor market circumstances on an hourly basis might earn by investing in certain penny stocks recognized for short-term gains.

Why should you invest in penny stocks

Penny stocks are very profitable and attract a significant number of investors. Here are a few justifications for investing in penny stocks:

Very affordable

The primary advantage of penny stocks is their cheap cost, and this makes them an excellent choice for novice investors or those with little capital to invest in stocks. If you examine the market, you may discover several excellent penny stocks selling for less than $1 per share.

Help you diversity

We are aware that variety is crucial, and it generates greater profits while minimizing exposure and minimizing risk. Penny stock investing may be a terrific method to get experience with a variety of investment stocks. In addition, because they are inexpensive to buy, you will be able to buy a variety of stocks without spending a lot of money.

Teach you more

Larger investments may yield significant returns, but they don't teach investors anything since they're not volatile and might be tedious to trade. On the other hand, Penny stocks are more volatile and provide investors with an opportunity to learn more.

Easy to learn

As a result of their steep learning curve, penny stocks are supposedly an excellent choice for novice investors. The combination of low prices and high volatility provides investors with a wonderful chance to learn the ins and outs of trading, which may be beneficial when expanding to bigger markets.

Offer high volatility

Penny stocks are very volatile and may fluctuate either way without notice. While this is true for all types of stocks, penny stocks reportedly provide higher volatility, and this makes them an excellent option for those who want to generate substantial income.

Why do penny stocks exist?

Despite the various hazards associated with penny stocks, they continue to exist because it is feasible to profit from them. Yes, it is difficult, yet investors in these stocks have generated substantial returns. In addition, some Pink Sheets firms are legitimate start-ups with great promise seeking investors to develop their operations. What you must understand is how to earn from penny stocks.


There is relatively little information accessible regarding penny stock businesses. Utilize reliable sources and financial documents to evaluate their revenue. Try to invest in penny stocks that sell 100,000 shares each day and firms operating in growth-oriented industries.

The price of a stock is also essential when evaluating it; just because it sells for 40 cents does not guarantee it has growth potential. In reality, these companies have minimal market capitalization, so do not be fooled by low prices. Typically, information on firms may be found on the SEC or company's websites, and the absence of information is a red flag.

Develop a diversified portfolio

Ensure you put aside a percentage of your funds for investing in penny stocks. Establish a budget and adhere to it. Invest the remainder of your stocks in other, more lucrative stock kinds.

This will minimize the total possible risk, and if you can tolerate a high level of risk, you can increase your budget; nonetheless, a few experts advocate investing no more than 10 percent of your income in penny stocks.

Avoid extra costs

Penny stocks currently do not guarantee profits, and thus it is vital to reduce their transaction costs. Avoid broker costs. Try to locate a broker that charges a flat amount rather than a commission per share.

Avoid scams

Maintain vigilance for pump and dump schemes. Examine the prices of a stock over the course of a week for extreme volatility, particularly in terms of volume. If it demonstrates consistency, you should invest in it. Additionally, do not fall for commercials that make hollow promises.

Low stock prices do not equal potential.

A solid rule of thumb is to buy stocks valued at or above 50 cents. A stock priced lower than that may be suspect, and if there is no information accessible about the firm, it is likely a hoax. Be practical. Know that penny stocks provide a very poor return on investment, and the likelihood of incurring an investment is greater than the likelihood of earning a return.

The dangers of trading penny stocks

Compared to typical stocks, penny stocks are accompanied by high risk. Among the hazards are the following:

1. Penny stock firms are very small. The majority of publicly listed corporations are significant enterprises that show their worth, which generally varies from hundreds of millions to over a trillion dollars. In contrast, the firms that issue penny stocks are often quite small, with even the biggest penny stock company typically having a market capitalization of far under $100 million.

2. Penny stock businesses lack credibility. It is uncommon for firms that you have experienced in your everyday life to be included among penny stocks. Penny stocks are often those of less established firms that have yet to demonstrate their ability to flourish.

3. Penny stocks don't trade on major stock exchanges. The New York Stock Exchange (NYSE) and the Nasdaq Stock Market (NASDAQ INDEX: IXIC) do not list penny stocks. Penny stocks are often traded OTC or over-the-counter. On the over-the-counter (OTC) market, reporting requirements are less stringent than on the NYSE and Nasdaq. Buying and selling shares of penny stocks may be rather difficult due to the illiquidity of stocks that are traded less often, i.e., the prevalence of significant spreads between the bid and ask prices.

4. Penny stocks are sometimes used in pump-and-dump operations. Con artists target penny stock investors by marketing a penny stock firm as the next hot investment. A penny stock's share price may be inflated by building excitement, and the price rise itself can be misrepresented as proof of the company's success. After the stock price rises, con artists often sell (dump) their shares for a profit and cease promoting the stock. The share price subsequently often drops, resulting in significant losses for late investors who believed the hype.

How much money should you invest in penny stocks?

Penny stock investment is certainly high-risk trading, and you should only participate in it with "fun money," not your rescue fund or retirement funds. Instead of depending on urban legends to fund your future, establish a diverse portfolio of low-cost, long-term investments.

Before trading into penny stocks or anything else, you should establish a mini-emergency fund of $500 to $1,500. This will significantly protect you against life's little irritants. A flat tire will not cause you to get out your credit card and incur debt due to the availability of this safety net. Having peace of mind is not just advantageous for businesses. Your next aim should be to establish a sizable emergency fund that can sustain you for three to eight months in the worst-case situation.

The optimum place for each of these accounts is a high-yield savings account that allows interest to collect and eventually compound. Interest compounding is a wonderful phenomenon, and this happens when the interest you have earned on your money continues to create interest, which in turn generates interest, etc.

The bottom line

Penny stocks are shares of tiny, publicly traded corporations that trade at very low prices. Penny stock firms might be brand-new to the capital markets startups, as well as existing businesses experiencing financial challenges and losing investor favor.

Even though penny stocks may seem to be attractive investment options owing to their very low prices, they are sometimes priced low because they are untested or have small odds of success. Nonetheless, a very dynamic research procedure may find a successful investment. But before you start looking for spare cash beneath your vehicle seat, you should educate yourself on the high-risk nature of penny stocks.

Frequently asked questions (FAQs)

Why do firms offer penny stocks?

Traditionally, Penny Stocks are issued by tiny, new enterprises in need of capital for expansion. However, old and reputable corporations may also sell Penny stocks if they are experiencing financial difficulties or are recovering from bankruptcy.

Are penny stocks a worthwhile investment?

Your investment approach will dictate whether or not penny stocks are a smart investment. If you are unwilling to face risks or if losing the money will jeopardize your financial stability, penny stocks and other hazardous investments may not be a smart decision.

Can penny stocks lead to wealth?

Penny stocks have some redeeming qualities, but they are not for everyone. These stocks may fast increase a little investment into a substantial sum of money, but they can also quickly wipe out an investment.

It looks intriguing that you can purchase shares of a company for pennies on the dollar, and if its value climbs to that of Amazon, you will become filthy rich.

Keep in mind, however, that a low price frequently indicates a company with high risk and a probability that it will not become profitable or survive in a few years. These shares are cheap for a reason.