How to invest in penny stocks in 2024 (2024)

Penny stock investing requires knowledge, an accumulation of experience and proper due diligence.

As with most, if not all, investments, there’s risk — sometimes significant — associated with investing in penny stocks. Some of this risk is specific to this class of diverse equities.

What are penny stocks?

While there’s variation depending on the source, investors tend to use two primary criteria to define penny stocks: market capitalization, which is a company’s total market value, and share price.

For example, the Securities and Exchange Commission (SEC) uses microcap (companies with market caps of less than $300 million) and penny stock interchangeably.

And financial services firm Charles Schwab says penny stock is a “catch-all term” that typically “refers to small public companies trading for less than $5 per share.”

The problem with these definitions is that not all microcap stocks trade for less than $5. And a low market cap doesn’t necessarily mean a sub-$5 share price.

What really defines penny stocks is the fact that they do not fulfill the necessary reporting requirements to trade on major US stock exchanges. Instead, penny stocks trade over the counter (OTC) through a network of broker-dealers.

Over-the-counter (OTC) market tiers

OTC Markets Group, which operates such networks for off-exchange public companies, further sorts companies into three tiers according to “the quality and quantity of information companies disclose.”

• OTCQX Best Market: To be clear, OTC Markets does not deal exclusively in penny stocks. In fact, penny stocks are not allowed in its top tier, OTCQX Best Market, which includes many large multinational firms that trade on top foreign exchanges. The remaining two levels — OTCQB Venture Market and the Pink Open Market — both include penny stocks.
• OTCQB Venture Market: Stocks that trade on the OTCQB Venture Market must have a minimum bid price of $0.01. They also need to be up to date in their regulatory reporting, provide audited financial reports and not be in bankruptcy.
• Pink Open Market: Requirements to trade on the Pink Open Market (also known as the “pink sheets”) are less stringent. OTC Markets publishes a list of requirements for Pink stocks that separates them into “Current” and “Limited” information levels based on the extent to which they report financials and other relevant information. As OTC Markets indicates, firms listed on the Pink market are not required to report to the SEC or other US or non-US regulatory or banking authorities, but they must comply with OTC Markets’ guidelines and its “Alternative Reporting Standard.”

OTC Markets used to have a “no information” level. However, in a rule mandated by the SEC, “These ‘No Information’ securities shifted to OTC Market Group’s Expert Market, where they are restricted from public viewing and only available to broker-dealers and other professional or sophisticated investors.”

This said, the pink sheets still include potentially risky companies due to the lower reporting requirements. At the same time, some companies simply do not have the financial wherewithal to comply with the regulations imposed by the major exchanges. Inclusion on the OTC markets gives them the opportunity to “provide shareholder value” while more effectively utilizing their time, money and other resources.

How to buy penny stocks

If you want to trade or invest in penny stocks, you generally go about it the same way — at least, logistically — as when you buy and sell other stocks. While some brokerages do not permit penny stock trading or place additional restrictions around low-priced securities, you can typically buy penny stocks through popular online brokerage accounts.

These accounts will need to provide access to OTC markets because, as noted, this is where penny stocks trade. Across its three distinct markets, OTC Markets Group gives investors access to more than 12,000 domestic and global tickers.

When you buy and sell penny stocks, you’ll be trading them on one of these OTC Markets tiers. While not regulated like stocks on the major exchanges, such as the New York Stock Exchange (NYSE) and Nasdaq, there are protocols in place to strive for transparency and protect investors.

To best understand how to invest in penny stocks, it pays to have a solid handle on how the market prices and values stocks, whether they’re penny stocks or large companies with much higher share prices.

Risks of penny stocks

One of the biggest potential pitfalls associated with penny stocks is that they — you guessed it — trade for pennies.

Investors are sometimes drawn to penny and other low-priced stocks because of their low stock prices. They consider them cheap when, in some cases, they’re anything but. For example, a stock that trades for $0.10 per share with underlying earnings of $0.01 per share is more expensive on a price-to-earnings (P/E) basis than, say, a $1 stock with underlying earnings of $0.50 per share. The former has a P/E ratio of 10 times, whereas the latter only carries a P/E ratio of two times. Without this understanding, investors might be attracted to the allure of owning thousands of shares in a penny or low-priced stock versus a small number or only a fraction of a share in a stock with a higher price.

Other than misinterpreting the price-valuation equation, there are other things to watch for when assessing penny stocks.

According to a 2016 SEC paper that’s still relevant in 2024: “Academic studies find that OTC stocks tend to be highly illiquid; are frequent targets of alleged market manipulation; generate negative and volatile investment returns on average; and rarely grow into a large company or transition to listing on a stock exchange. Moreover, these properties tend to worsen when the OTC company has fewer disclosure-related eligibility requirements.”

The SEC succinctly nailed these risks. Let’s expand on some of them.

Penny stock manipulation

The reality is that many companies that trade as penny stocks lose money. They often have no earnings to speak of. It’s due to this and, in many cases, generally poor financial condition that they trade as penny stocks in the first place. This is where trouble can arise.

Bad actors are also among the biggest risks in penny stock investing. Market participants with nefarious intentions sometimes encourage and even manipulate investors into buying penny stocks using the low — and seemingly inexpensive — stock price as bait amid unfounded and sometimes blatantly untrue claims about a company’s current situation and expected success.

Pump-and-dump scams often take place with penny stocks. “In a pump and dump scheme,” the SEC warns, “fraudsters typically spread false or misleading information to create a buying frenzy that will ‘pump’ up the price of a stock and then ‘dump’ shares of the stock by selling their own shares at the inflated price.”

If it sounds too good to be true, there’s a good chance it is. If somebody on social media, in a Reddit forum or elsewhere, hypes a penny stock, stay away. At the very least, do your diligence separate from the hype.

Part of the SEC’s job is to look out for and punish this type of activity. The SEC regularly busts people for all types of illegal market activity, including market manipulation and penny stock pump-and-dump schemes that often originate on social media.

Liquidity concerns

Penny stocks tend to trade in relatively lower volumes, with wider bid/ask spreads and less liquidity, which simply means you might not be able to buy or sell OTC stocks as quickly and efficiently as you can more heavily traded names, particularly stocks listed on the major exchanges. Due to these and other factors, Schwab calls OTC stocks “volatile” and “usually speculative in nature.”

Are penny stocks worth it?

Whether penny stocks are worth it or not depends on your goals, place in life, overall financial position and how well you stomach potentially and actually losing money.

All types of investors speculate — sometimes on unproven companies that raise red flags. They frequently get burned. Occasionally, they make money. But don’t let a victory or two breed overconfidence. Overconfidence can lead to investors ignoring what the stock market is “saying” about a company’s valuation. Penny stocks embody one of the most extreme examples of this psychological dynamic.

Frequently asked questions (FAQs)