What Is a Penny Stock? Definition, Trading, and Regulation

Penny stocks are a category of securities issued by smaller companies that typically trade outside of major stock exchanges. They are characterized by low share prices. This article explores what defines a penny stock, how it trades, and the regulations that apply to it.

Defining Penny Stocks

The U.S. Securities and Exchange Commission (SEC) defines a penny stock as a security that trades at less than $5 per share. This definition applies to shares issued by small public companies. While the term historically referred to shares trading for actual pennies, the contemporary definition encompasses a broader range of low-priced equities. These securities often originate from companies with a relatively small market capitalization.

Companies whose shares are categorized as penny stocks exhibit certain characteristics that differentiate them from larger corporations. They are often in early stages of development, possessing limited assets and sometimes an unproven business model. These companies may not meet the stringent listing requirements of major national stock exchanges like the New York Stock Exchange (NYSE) or Nasdaq. Listing on these exchanges demands adherence to minimum share price thresholds and specific financial and corporate governance standards.

Securities listed on national securities exchanges are exempt from the SEC’s definition of a penny stock, regardless of their price. This exemption exists because exchange listing standards offer investor protection and company oversight. Companies that fall below a major exchange’s minimum share price requirement risk being delisted and may then be classified as penny stocks if their price drops below the $5 threshold.

Trading Penny Stocks

Penny stocks are primarily bought and sold in the over-the-counter (OTC) market, rather than on traditional centralized exchanges. This decentralized market operates through a network of broker-dealers who negotiate directly. Key platforms within the OTC market include OTC Link LLC, which encompasses the OTCQX, OTCQB, and OTC Pink marketplaces.

Broker-dealers facilitate the trading of penny stocks by quoting prices and executing transactions. When a customer wishes to buy or sell a penny stock, the broker-dealer will provide a bid price (the price at which they are willing to buy) and an offer price (the price at which they are willing to sell). The difference between these prices, known as the spread, can be substantial. While some penny stocks may trade on major exchanges, the majority are traded over-the-counter.

Brokerage firms offer access to OTC penny stock trading. These firms may provide various tools and research capabilities to assist in trading these securities. Some brokers may charge additional fees for OTC trades, while others offer commission-free trading for these assets. The process involves placing an order with a broker-dealer, who then seeks to match the order within the OTC network.

Regulatory Oversight

The U.S. Securities and Exchange Commission (SEC) maintains a regulatory framework for penny stocks to address risks associated with these securities. The Penny Stock Reform Act of 1990 directed the SEC to adopt rules concerning sales practices and disclosures for these low-priced securities. As a result, the SEC implemented rules such as Rule 15g-9, the “penny stock rule,” which imposes specific requirements on broker-dealers when transacting in penny stocks with non-established customers.

Before a broker-dealer can effect a transaction in a penny stock, they must approve the customer’s account for such trades and receive a written agreement. This approval process involves obtaining information about the customer’s financial situation, investment experience, and objectives. Broker-dealers are required to provide customers with a standardized risk disclosure document, known as Schedule 15G, which outlines the risks of investing in penny stocks. This document must be delivered prior to the customer’s first penny stock transaction.

Companies whose shares are traded as penny stocks, particularly those not listed on major exchanges, have less stringent public reporting requirements. Many microcap companies do not file regular financial reports with the SEC, making it challenging to access comprehensive information about their business operations, financial condition, or management. Broker-dealers are also obligated to disclose to customers the current bid and offer quotations for the penny stock, the number of shares associated with those quotes, and the compensation the firm and its salesperson will receive from the trade. Monthly account statements are required, showing an estimated value of the penny stocks held in a customer’s account.