What’s a penny stock?
Let’s take a look at what penny stocks are, why people invest in them, and the risks of investing in them.
What’s a penny stock?
‘Penny stock’ is a colloquial term for companies with inexpensive shares, also known as a ‘small cap’ company—although shares will often be more than the 1 cent that the name suggests!
They tend to have these characteristics:
Small market capitalisations—the company’s total worth is a lot less than bigger companies.
Low liquidity—its shares are bought and sold infrequently.
A penny stock is basically the opposite of a blue chip company. To refresh your memory: blue chips tend to be established, large companies with large market capitalisations. They’re often recognisable names—big banks, supermarkets, and other brands you recognise.
Penny stocks are smaller, niche companies. They may be new companies too, without a track record.
One benefit of penny stocks is in the name—their share prices are often very low! But the low price of each penny stock share is because they can also come with a lot of risk. Their share prices can move around a lot, by significant margins. They can also have a higher chance of becoming completely worthless, which means you could lose your entire investment.
Penny stocks: high risk speculation
Penny stocks can be speculative. This means they may not be worth very much right now, but some people think they might be worth a lot more in the future.
Of course, you have no way of knowing if they will actually be worth a lot in the future, or if they may end up being worth nothing. That’s the nature of speculation.
Small mining companies can be an example of a speculative penny stock. The company might own some land (or the rights to dig up some land) that may have valuable minerals in it, without knowing if the minerals are actually in there or not.
If they find minerals, the company could be worth a lot more than it currently is, because they’ll be able to sell those minerals for a lot of money. But if they don’t, then the company could effectively be worth nothing.
Another example could be a medicine company looking to get approval from the authorities to sell a new drug. If it gets approval, then it could be more than it is now, as it brings a new drug to market. If it doesn’t, then the company won’t be able to sell anything—and its shares could be worth nothing.
The same goes for companies looking for patents for a new product. If they get the patent, they’ll have exclusive rights to sell whatever it is they’ve invented. If they don’t, then their idea can be copied by anyone—making their road to success a lot harder!
So while investing in penny stock companies may come with growth potential, it can also come with significant risk.
Volatility and liquidity
We talked about the big, obvious tradeoff with penny stocks: they can have a high likelihood of losing all their value. But there’s another big tradeoff, too: volatility. Penny stocks can have big swings up and down in their share price over short periods of time. A key reason for this is because penny stock companies can have low liquidity.
Liquidity comes from how often people are buying and selling shares throughout the day. If an investment has high liquidity and there are lots of trades happening, then you can usually be pretty confident that you can buy or sell shares at a price similar to what you might see when you place your order.
This is not the case with penny stocks. Since penny stocks are so niche, there’s often a lot less buying and selling going on through the day. This means that if you want to sell penny stock shares, you may have to wait for a buyer—or instead, sell at a discount. Or if you want to buy, you may have to pay a premium for your order to be filled.
And remember, the other people who own the penny stock shares are in the same situation. This means that the price can go up and down really quickly as people either buy up shares at a premium, or offload them at a discount—even if nothing has changed with the underlying company.
Go in with your eyes open
If you’re going to invest in penny stocks, think about why they might be so cheap. After all, even a cheap share is too expensive if it’s worth nothing in six months. They may come with opportunity, but that opportunity comes with risk.
Ok, now for the legal bit
Investing involves risk. You aren’t guaranteed to make money, and you might lose the money you start with. We don’t provide personalised advice or recommendations. Any information we provide is general only and current at the time written. You should consider seeking independent legal, financial, taxation or other advice when considering whether an investment is appropriate for your objectives, financial situation or needs.