Penny stocks are low-priced, small-cap shares of companies that trade outside major market exchanges and carry a high degree of speculative risk.
Understanding penny stocks
The exact price threshold for these shares varies by country. In the United States, regulators define penny stocks as shares trading below $5. In the United Kingdom, they are typically shares trading for less than £1. Other markets maintain similar benchmarks, such as shares priced under $1 AUD in Australia. These shares are issued by small companies and generally trade over the counter or on smaller regional exchanges, though some are listed on major national indices.
These stocks have low liquidity. This means there are fewer buyers and sellers actively trading the shares. When an investor wants to sell their position, they might struggle to find a buyer at the quoted price. This lack of liquidity leads to high volatility. A single small trade can cause the share price to move aggressively up or down.
Companies issuing penny stocks often have limited historical financial data. They are not subjected to the strict reporting requirements expected of large-cap companies. Investors face the risk of losing their entire investment. These shares are frequently targeted by market manipulation schemes like pump and dump operations. In these operations, promoters artificially inflate the stock price before selling off their holdings to unsuspecting buyers.
Elephants trading in these markets should monitor the bid-ask spread. The spread is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. Penny stocks often have wide bid-ask spreads. This spread acts as an immediate cost to the investor upon entering the trade.
Example
An investor buys shares in Savannah Tusks Ltd, a small start-up company that manufactures automated watering troughs for elephant sanctuaries. The company trades over the counter at $0.15 per share. The investor buys 10,000 shares for $1,500. Due to low trading volume, the bid price drops to $0.10 while the ask price remains at $0.15. If the investor immediately tries to sell the shares, they can only get $0.10 per share, resulting in a sudden $500 loss. A few weeks later, an online newsletter promotes Savannah Tusks Ltd. This promotion causes the price to briefly jump to $0.40. The early investors sell their shares, the price collapses back to $0.05, and late buyers lose the majority of their money.