How penny stocks are traded — and why they’re so risky for investors

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Penny stocks are small companies whose shares trade for a relatively low price and often on thin volume. They are considered speculative investments and can be highly volatile, appealing to traders trying to capture outsized returns. However, the losses can be just as severe.

But not all penny stocks are the same, and one factor that sets them apart is where they trade.

How are penny stocks traded?

According to the U.S. Securities Exchange Commission (SEC), penny stocks are shares of equities that trade for under $5. Some of these companies are new to the market, may not have complete financial records, or lack a solid product, service, or revenue stream. In certain instances, some of them could even be going through bankruptcy filings.

Companies with all their documents in order can list on major stock exchanges like the NYSE or NASDAQ, which have strict rules, such as frequently disclosing financial statements with the SEC.

Since most penny stock issuers do not qualify to list on a large exchange, their shares trade over the counter (OTC) via the OTC Bulletin Board (OTCBB), an electronic trading service managed by the Financial Industry Regulatory Authority, or via the private Pink Sheets marketplace.

For the penny stock issuers that file financial statements with the SEC, their ticker symbols start with an “OB” suffix on the OTCBB. For penny stocks trading on the Pink Sheets platform, their ticker symbols have a “PK” suffix.

For retail investors, it’s important to note that over-the-counter trading takes place between parties outside a major stock exchange and without the supervision of an exchange regulator or a market maker to ensure liquidity in the stock.

The absence of a more stringent listing process and low liquidity, for example, open the door for numerous risks such as potential market manipulation.

What other factors make penny stocks risky?

Investors often rely on publicly available information to assess a potential investment opportunity. This information can be from reputable news outlets, a broker’s research team, SEC filings, and so on. However, these materials can be hard to find for small companies and may not always come from trustworthy sources.

Since some of the penny stock issuers are newly formed, historical data isn’t likely to be available, making it challenging for investors to assess current and future valuations.

Similarly, not all penny-stock companies are required to disclose financial statements. As a result, these businesses may not receive the same level of investor oversight as more established names like blue-chip stocks. Pink Sheet stocks are thought to be the riskiest because issuers are not required to disclose any financial information.

Low trading volumes also provide opportunities for astute traders to take advantage of volatility — often driving prices on penny stocks artificially higher (or sometimes lower).

For example, in a “pump-and-dump” scheme, traders will incentivize investors to get in on the next “hot stock,” causing the share price to rise quickly as buying orders come in. But when investors come to their senses and realize the inflated prices are likely unwarranted, those stocks often come crashing down, leaving those who bought at high levels holding the bag.

Are penny stocks a good investment?

For small businesses, listing their stock publicly helps them access public funding, which can be their lifeline as they attempt to grow. And for investors, supporting the companies that succeed can be lucrative – particularly if those products or services really take off.

Of course, for investors, identifying a winner in a sea of penny stocks could be viewed as finding a needle in a haystack.

When it comes to penny stocks, the appeal for traders is the potential for making significant returns with small amounts of capital. So, while a large stock like Apple typically trades within a 2 percent range over the course of a day or week, a penny stock could see its shares move north of 10 percent or more in either direction during a single day.

Because of the added volatility and the low share price, many penny stock traders see it as an opportunity to make quick profits. And to mitigate the risk associated with companies trading over the counter, they go after penny stocks listed on large exchanges like the NYSE.

There are plenty of strategies on how to trade penny stocks. But, like other investments, it’s always prudent to do your homework, look at the financial filings, start small, and avoid letting greed or fear influence your decision-making.

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Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.

Written by
Giovanny Moreano
Contributing writer
Gio Moreano is a contributing writer, covering investment topics that help you make smart money decisions. Formerly an investing journalist and lead analyst for CNBC, he is passionate about financial education and empowering people to reach their goals.
Edited by
Senior wealth editor