PENNY STOCKS EXPLAINED: RISKS, SCAMS & VOLATILITY

Penny stocks refer to shares of small public companies trading at low prices, typically under $5 per share. They are usually traded over-the-counter (OTC) via platforms like the OTC Bulletin Board (OTCBB) or the pink sheets, rather than on major exchanges such as the New York Stock Exchange (NYSE) or Nasdaq. Due to their low market capitalisation, limited liquidity, and light regulatory oversight, penny stocks are considered speculative and risky investments.

The idea behind penny stocks often appeals to investors seeking high returns with limited capital. While the price per share may be low, the associated risks are disproportionately high. Penny stocks are typically issued by smaller, lesser-known companies, which may be newly established, under financial distress, or not fully transparent in their operations or finances.

In the UK, penny stocks are referred to as "small-cap stocks," often traded on the Alternative Investment Market (AIM). These shares tend to have low trading volumes, making them more illiquid and open to price manipulation.

Common Characteristics of Penny Stocks

• Low share price: Generally priced under $5 (in the US), or lightly capitalised stocks on secondary markets in the UK.
• Low market cap: Typically small-cap or micro-cap companies with minimal resources.
• Limited financial reporting: Often operate outside the scope of stringent financial reporting required by larger exchanges.
• High volatility: Small trades can lead to large price swings due to limited trading volumes.

Penny stocks are seen as a breeding ground for speculative investing, where success stories are rare but heavily marketed. While some have risen to prominence after initial obscurity (e.g., companies like Monster Beverage), such examples are exceptional, not the rule.

Essentially, penny stocks represent a potential for high return paired with exceptional risk. Their allure lies in the idea of getting in early on the “next big thing,” but they require a cautious and informed investment strategy.

Liquidity risk in penny stock investing refers to the difficulty in buying or selling the stock without significantly affecting the price. With few buyers and sellers, any large transaction can skew market valuations—resulting in potential losses for investors trying to enter or exit positions.

Because penny stocks often trade on less regulated exchanges or over-the-counter (OTC) networks, their prices are not always reflective of underlying fundamentals or true market consensus. This thin trading volume compounds liquidity issues, making it harder to determine a fair market value.

Understanding Liquidity Risks

• Wide bid-ask spreads: The difference between the buying and selling price can be significant, making real-time exits costly.
• Trade execution delays: Orders may take longer to fill, especially during volatile periods or in off-hours trading.
• Price manipulation: Illiquidity opens the door for artificial price boosts through tactics like "painting the tape" or “wash sales.”

Penny stock scams are unfortunately quite common. These equities' low visibility and weak oversight make them easy targets for fraudsters. The most notorious schemes include:

Common Types of Penny Stock Scams

• Pump and dump: Fraudsters artificially inflate the stock price through misleading statements, then sell off their holdings at a profit, crashing the price.
• Boiler rooms: High-pressure sales tactics used by brokers to coax unsophisticated investors into buying questionable stocks.
• Fake press releases: Dissemination of false information to spike interest and price temporarily.

Regulatory bodies such as the U.S. Securities and Exchange Commission (SEC) and the UK’s Financial Conduct Authority (FCA) have issued multiple warnings about penny stock scams. Yet, they remain prevalent, particularly during market mania phases or economic uncertainty.

Due diligence is critical. Savvy investors comb through available financial disclosures, analyse trading patterns, and consider the company's fundamentals—if such information exists. In many cases, penny stocks do not file audited financial statements, making reliable analysis nearly impossible.

In summary, penny stock investors face a dual threat: illiquidity that hinders efficient trading, and frequent exposure to fraudulent schemes. These risks amplify the importance of prudence and comprehensive research before taking a position.

Penny stocks exhibit extreme price volatility due to a combination of structural and behavioural factors. Their small market capitalisations mean that smaller trades can cause significant price fluctuations. Additionally, the lack of robust reporting mechanisms, coupled with limited analyst coverage, allows speculative sentiment to override fundamentals.

Factors Behind Penny Stock Volatility

• Low liquidity: Sparse trading leads to large bid-ask spreads and erratic price action.
• Speculative trading: Investors often chase the potential for huge gains based on rumours or vague news.
• Lack of institutional support: Hedge funds and large asset managers typically avoid these stocks due to compliance concerns, leaving the market dominated by retail investors.

The volatility can be both a draw and a danger. While large, rapid gains capture investor attention, they are usually short-lived and unsustainable. Inexperienced traders may enter positions without a clear strategy or exit plan, leading to high emotional trading and quick losses.

Moreover, some of the price volatility is driven by momentum-based algorithms. Certain trading bots are programmed to exploit price swings, adding fuel to the fire and delivering more turbulent sessions, especially for inexperienced retail investors.

Psychology of Penny Stock Volatility

Behavioural finance plays a major role. Many investors are drawn to penny stocks out of a desire to “get rich quick.” This speculative mindset makes the segment particularly vulnerable to herd behaviour, where fear and greed dominate rational thinking.

News—whether real or fake—has an outsized impact. A single press release, forum post, or viral tweet can dramatically shift the market for a low-float stock. This environment creates fertile ground for manipulation and makes volatility an ever-present risk.

Historical Volatility Events

Numerous penny stocks have seen price movements of 100% or more in a single trading session—movements that are rare in larger, more stable companies. For example, during the 2020 market surge powered by retail traders using social apps, several penny stocks experienced parabolic rallies followed by steep crashes.

In summary, penny stock volatility is not unintended—it is a structural feature of these investments. The low barriers to entry, small price base, and susceptibility to emotion and misinformation create an atmosphere of high risk and unpredictability.

Volatility is not merely a side effect but a defining trait of penny stocks. For some traders, this volatility can be exploited profitably. For most investors, however, it represents a red flag demanding caution, discipline, and discretion.