6 Things to Know About Penny Stocks

In a world where securities worth hundreds (or even thousands) of dollars tend to steal the investing spotlight, penny stocks are a bit of a maverick. They appear inexpensive. They can be unpredictable. They often don't play by the rules. And while penny stocks have gained in popularity in recent years, they do come with significant risks for investors. It's important to understand those risks to help determine if these securities are right for you. Let's take a look at six common questions investors ask about penny stocks.

What are penny stocks?

Penny stocks go by many names (pink sheet stocks and microcaps, for example), but as a rule of thumb they typically trade at $5 or less — sometimes even for fractions of a cent in the case of so-called "triple-zero" stocks. They are generally not listed on traditional exchanges and are not to be confused with sub-$5 securities trading via TSX or NASDAQ, which meet several strict disclosure and valuation standards that penny stocks do not.

How risky are penny stocks?

Penny stocks can be attractive to some investors because they have the potential to dramatically increase in value. (High risk/high reward.) For example, the announcement of an exciting new product line or a buyout offer can send shares soaring from a few cents to a couple of dollars, potentially doubling or tripling an investor's money in a matter of days. Of course, the opposite can just as easily happen. Penny stocks' volatility makes them one of the riskier investments out there. In addition to wide bid/ask spreads, penny stocks can be very illiquid, which can make it difficult to buy or sell when you want to. Plus, the last trade (closing price) can often be an inaccurate indication of the current market price – which could result in a fill that's much different than what you were expecting. When placing orders, limit orders offer greater protection against undesirable pricing.

Where do penny stocks trade?

Penny stocks are largely bought and sold by dealers on the over-the-counter (OTC) market. In this loosely regulated and unmonitored environment, brokers submit bids and offers in a variety of ways, including over the phone or on electronic bulletin boards like the OTC Bulletin Board. It's important to pay attention to volumes when trading penny stocks; many have low trading volumes, which can make buying and selling more difficult. Regulatory or settlement restrictions can also impact trading in penny stocks.

Can I hold penny stocks in registered accounts ?

Securities that trade only on OTC markets are often considered non-qualified investments. That matters because the Canada Revenue Agency (CRA) tracks the types of investments that are eligible for registered plans (like TFSAs and RRSPs, for example) and can impose tax penalties for any non-qualified investments held within them. A security usually meets the requirements of a qualified investment if it trades on at least one exchange that's considered a Designated Stock Exchange as determined by the Department of Finance Canada. However, stocks that trade only on OTC markets would generally be considered non-qualified investments, and therefore not eligible for registered accounts. Find out more in Owning a Non-Qualified Investment Can be Costly.

Why are they so cheap?

Penny stocks are usually priced low for a reason. For example, they could be sold by a company struggling financially, facing legal trouble or reeling from a scandal. They may also be sold by a brand-new company with a lot of growth potential, or an established player down on its luck (and hoping for a rebound).

Why is there so little company information for some?

There's often very little information to be found about some of the companies that trade as penny stocks. They may represent shell companies, could be new and unproven business, may have few assets, or just haven't disclosed details about their operations — largely because they're not required to since they aren't listed on major exchanges. Amid this lack of data, there is proportionally more disinformation working against an investor — which can sometimes include promoters being paid to hype shares. Penny stocks' susceptibility to manipulation is how they became (in)famously associated with the "pump-and-dump" scheme (an illegal practice in which a company's stock price is boosted based on the sharing of positive, but fake, information).

As with all investments, but perhaps particularly with penny stocks, research and knowing how much risk you're comfortable with are key when determining if they're right for you.