Penny Stocks, Microcaps, and OTC Stocks Explained

Narrator: Penny stocks can be used as a catch-all term for several types of speculative stock investments, but, most commonly, it refers to small public companies trading for less than $5 per share. Penny stocks are typically not listed on U.S. stock exchanges like the NYSE or Nasdaq^®. Instead, they're traded through a different method called over the counter, which is why they're also called OTC stocks. Note that not all OTC stocks are under $5 per share, but we'll discuss technical definitions later.

Some traders are drawn to penny stocks because their low price means they can buy a lot of shares and profit from small changes in the stock price. However, high volatility and frequent fraud can make investing in penny stocks and similar speculative securities very risky. Understanding some key definitions, as well as the unique risks that come with trading these speculative securities, can help you make more informed investing decisions.

When trading penny stocks and other speculative securities, it's important to understand some technical terms. The term "penny stocks" is sometimes mistakenly used interchangeably with micro-caps, OTC stocks, pink sheets, and gray sheets, but the securities industry uses each term in distinct ways.

A micro-cap stock is generally considered any stock with a market cap of $50 million to $300 million. However, not all micro-caps are penny stocks.

OTC, or over-the-counter, stocks include all stocks that are not traded on a U.S. stock exchange. Instead, they trade through dealer-to-dealer networks.

Most penny stocks and microcaps do trade over the counter, but not all OTC stocks are small. OTC stocks can be big or small, foreign or domestic, or can deal in products that are considered illegitimate in some places, like marijuana stocks. What OTC stocks have in common is not having the same reporting requirements as stocks traded on major exchanges.

A final group of speculative stocks to be aware of is gray sheets. These stocks haven't filed the necessary paperwork to trade over the counter, so they trade in the gray market with limited pricing information available.

What many of these types of stocks have in common is higher-than-average risk, which stems from two main factors: lack of information and low liquidity.

Because they don't have the same reporting requirements as stocks traded on major exchanges, many OTC companies offer little information for public analysis, and stock analysts rarely cover them.

Without this data, it can be difficult to know which companies may have a weak business track record or be on the brink of bankruptcy.

These risks are compounded by low liquidity, which may make it difficult for traders to get orders filled near their desired price or filled at all. With low liquidity, large orders can easily move the price. In the case of stocks under $5, a move of a few cents can mean a major percentage gain or loss, illustrating the tremendous volatility.

This lack of information and liquidity make penny stocks and similar speculative securities particularly vulnerable to fraud. For example, fraudsters have been known to use social media, direct email campaigns, and discussion boards to promote a stock in an attempt to drive up the price. Then, they profit by selling their own shares to unsuspecting traders, causing the stock price to collapse. This is an illegal strategy known as pump and dump. In 2018, one stock promoter was convicted for inflating the value of shares by approximately $100 million.

With all of this risk and lack of information, you may wonder why anyone would trade penny stocks. Some investors believe that they may be able to get in on the ground floor of highly risky companies that may be ready to break out and grow. Others see low prices as a way to buy a lot of shares and profit from small changes in the stock price.

For these reasons, trading in OTC stocks remains popular.

If you're willing to take on the risk for the potential return, make sure you have a plan. First, do your homework by studying the companies you're interested in. Do as much research as you can using multiple resources, if possible.

It's also important to be aware of the level of risk associated with different types of companies.

For example, OTC Markets Group categorizes stocks by the amount of regulatory reporting done, ranging from those that regularly provide financial data to the SEC or a U.S. bank to those that provide none.

And don't forget traditional risk management strategies like planning entries and exits, using limit orders to help ensure you're getting a price you like, and investing relatively small amounts to increase your chances of getting filled and limiting losses.

If you find yourself delving into penny stocks, micro-caps, or OTC stocks, remember to weigh the risk and return, do your research, and tread carefully. An ill-informed foray into penny stocks could leave you penniless.

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