What are penny stocks?

What are penny stocks?

Penny stocks are common shares of smaller companies traded for less than £1 in the UK. The market cap on penny stock companies is typically below £100 million, distinguishing them from mid-cap and large-cap companies.

The general sentiment behind investors buying penny shares is that you bet on a small company that'll grow over time. This adds an element of risk, but some consider it to also have high rewards.

Consider some of the best penny shares to watch.

Where penny stocks trade

In the UK, penny stocks primarily trade on two exchanges: AIM (Alternative Investment Market) and the Main Market. AIM is the London Stock Exchange's junior market, designed specifically for smaller growing companies.

It has lighter regulatory requirements than the Main Market, making it easier and cheaper for companies to list. However, this also means less regulatory oversight and potentially higher risk for investors.

Some penny stocks do trade on the LSE Main Market, typically companies that have fallen in value or very small companies that meet the more stringent listing requirements.

The key difference between these venues is regulatory rigour. Main Market companies must comply with the UK Listing Rules and provide more extensive financial reporting. AIM companies follow AIM Rules for Companies, which are less demanding but still require a Nominated Adviser (NOMAD) to ensure some level of oversight.

Beyond the growth potential, AIM shares provide unique tax advantages that make them particularly attractive for certain investors. Qualifying AIM shares can offer some Business Relief for Inheritance Tax after two years of holding, and they can be held within ISAs and SIPPs, providing tax-efficient wrappers for your investments.

However, these benefits come with trade-offs that investors must carefully consider. AIM companies experience a higher failure rate than Main Market firms, partly due to their earlier stage of development and the less stringent regulatory environment.

Liquidity tends to be lower on AIM, meaning you may struggle to buy or sell shares quickly without impacting the price. This lower liquidity often results in wider bid-ask spreads, immediately putting you at a disadvantage when entering positions. Additionally, AIM companies receive less analyst coverage, meaning you'll need to conduct more of your own research.

The lighter disclosure requirements, while reducing costs for companies, also mean less information is available to help you make informed decisions.

How to invest in penny stocks with us

1. Learn more about penny stocks
2. Download the IG Invest app or open a share dealing account online
3. Search for your preferred penny stock on our app or web platform
4. Choose how many shares you’d like to buy
5. Place your deal and monitor your investment

Investors look to grow their capital through share price returns and dividends - if paid.

But the value of investments can fall as well as rise, past performance is no indicator of future returns, and you could get back less than your original investment.

Are penny shares more volatile?

Penny shares are often more volatile than other stocks, because they belong to companies that are either very small or newly listed. This means that they're sensitive to market news and developments, and there's low liquidity. On the other hand, this also means there could be more room to grow.

Since penny stocks trade at a lower price point, an incremental movement in their value could translate into a high percentage share price change quite easily. A 5p move on a 50p share represents a 10% change, whereas the same 5p move on a £10 share is just 0.5%. This mathematical reality creates the illusion of dramatic swings that can be both exciting and unnerving for investors.

Low liquidity is one of the biggest challenges with penny stocks, and its implications extend far beyond simple inconvenience. The difference between the buying and selling price (the bid-ask spread) can be significant, sometimes 5-10% or more. This immediately puts you at a loss when you buy, meaning the share price must rise substantially just for you to break even.

When you want to sell, there may not be enough buyers willing to take your shares at the price you want. You might need to accept a lower price or sell in smaller batches over time, turning what should be a simple exit into a drawn-out process.

Even modest-sized orders can move the share price significantly due to thin trading volumes, meaning your own buying or selling activity can work against you.

Many penny stocks rely on market makers to provide liquidity, and understanding their role is crucial for any serious penny stock investor.

Market makers profit from the spread between buying and selling prices, and they may widen this spread during volatile periods precisely when you most need to exit a position. This dynamic creates an additional layer of complexity and risk that doesn't exist with more liquid investments.

Spotting red flags

Sadly, penny stocks can be problematic:

1. Pump and dump schemes — Fraudsters buy cheap shares, spread false hype through social media, forums, or fake news, then sell at inflated prices, leaving ordinary investors with heavy losses.
2. Unsolicited tips — Be wary of “guaranteed returns” or “insider info” shared via emails, DMs, or cold calls; coordinated multi-channel promotion and sudden unexplained price spikes are classic red flags.
3. Shell companies — Some firms exist only on paper, with polished branding but no genuine operations or revenue, often used for fraud, money laundering, or deceptive market manipulation.
4. Chronic losses — Companies repeatedly posting losses with no credible path to profitability are best avoided; exciting stories mean little without a viable, cash-generating model.
5. Dilution and insider selling — Frequent discounted share placings and directors offloading stock signal financial distress and management’s lack of confidence in future prospects.
6. Regulatory and governance red flags — Losing or changing AIM Nominated Advisers, missing filing deadlines, or lacking institutional investor support all suggest deep structural problems.

Best penny stock sectors to watch

Biotech and pharmaceuticals represent a significant portion of the penny stock space. Many small drug developers trade at low valuations while working through clinical trial phases, offering high risk but potentially enormous rewards if their drugs gain regulatory approval.

The binary nature of drug development means these investments can go to zero or multiply many times over based on single trial results.

Mining and natural resources companies, particularly explorers, often trade as penny stocks until they hopefully make significant discoveries or commodity prices rise substantially. These companies offer leveraged exposure to commodity prices, but they're also capital intensive and subject to factors beyond their control.

Technology startups, including software, gaming and emerging tech companies, frequently list on AIM as penny stocks while building their businesses. The best can grow exponentially, while many others burn through capital pursuing unviable products.

Renewable energy companies working to commercialise solar, wind, and other green technologies have become increasingly common as penny stocks, supported by favorable policy environments but facing technological and execution challenges.

Specialist manufacturing businesses serving specific niche markets can also thrive as penny stocks. These companies often fly under the radar of larger investors but can build sustainable businesses with strong margins and loyal customer bases.

Building your penny stock strategy

Portfolio allocation

Even advocates of penny stock investing typically recommend limiting your exposure to this high risk asset class. Aggressive investors might allocate a maximum of 10-15% of their portfolio to penny stocks, while moderate investors should consider limiting exposure to 5-10%. Conservative investors should either avoid penny stocks entirely or allocate no more than 5% of their portfolio. 

Position sizing

Within your penny stock allocation, individual position sizes matter enormously for risk management. Many think that no single position should exceed 5% of your investment portfolio, ensuring that even a complete loss won't devastate your finances. Consider reserving larger positions of up to 5% only for your highest conviction ideas with better fundamentals, proven management teams and clearer paths to profitability.

Diversification within penny stocks

It can make sense not to concentrate all your penny stock allocation into one sector, no matter how promising it appears. Spread your investments across different industries to protect against sector-specific downturns. Mix different stages of company development, combining early-stage ventures with more established small companies that have proven business models. 

Entry and exit strategies

Timing your entry into penny stocks can significantly impact your returns. Consider entering positions after significant price drops if the underlying fundamentals remain intact, as panic selling often creates opportunities.

Following positive results or contract announcements can work, though be aware of the 'buy the rumour, sell the news' dynamic where prices peak on the expectation of good news. Broader market selloffs can also unfairly punish quality companies, creating buying opportunities for patient investors. 

Your exit strategy is equally important and should be planned before you enter any position. Set target prices and consider implementing stop-losses to limit downside, though be aware these can be triggered by normal volatility in penny stocks. Taking partial profits as prices rise allows you to lock in gains while maintaining upside exposure.

You might exit completely if your investment thesis breaks down and consider scaling out in stages rather than selling your entire position at once, which allows you to capture further upside if the move continues while protecting some gains.

Time horizons

Penny stock investing typically requires patience and longer time horizons than many investors expect. Short-term trades lasting days to weeks carry high risk and require constant monitoring.. Swing trades over weeks to months can capitalise on news flow and momentum but still demand significant attention and skill.

Most successful penny stock investors adopt a long-term perspective, holding positions for years and allowing business models to mature and compound. Accepting that many positions will take 2-5 years to fully play out requires emotional discipline and conviction in your research, but this approach has historically produced the best results for patient investors.

How to research penny stocks

1. Start with the Annual Report — Access company filings on Companies House or the firm’s website to analyse revenue trends, profit margins, and—most importantly—cash flow, which determines survival.
2. Check balance sheet strength — Assess debt levels relative to cash generation and company size, and review director pay for alignment with performance—excessive remuneration in weak firms is a red flag.
3. Monitor RNS updates — Follow Regulatory News Service announcements for trading updates, contracts, fundraisings, and material developments; review IPO or reverse takeover documents for full background detail.
4. Focus on growth metrics — Track revenue growth versus competitors and examine EBITDA and operating margins to see whether profitability is improving as the business scales.
5. Analyse cash burn and valuation — For loss-making companies, calculate how long cash reserves will last, and use price-to-sales ratios to gauge valuation against peers.
6. Evaluate leverage and liquidity — Use net debt to EBITDA to measure financial risk and review working capital to ensure the business can operate without constant funding needs.
7. Assess management quality — Research directors’ track records through Companies House, noting prior business successes or failures, as leadership quality often dictates long-term outcomes.
8. Understand the business model and moat — Ensure you clearly grasp how the company makes money, what differentiates it from competitors, and whether it has a defensible market position with diversified customers.

Pros and cons of penny stocks

As with all market segments, penny stocks come with their own unique set of advantages and drawbacks:

Pros of penny stocks

• Under-analysed — smaller companies often fly under the radar of institutional investors and analysts, creating opportunities to buy quality businesses at depressed valuations
• Liquidity gap — when major fund managers can’t take meaningful positions due to liquidity constraints, retail investors can sometimes spot value that others have missed.
• Faster growth potential — small companies can grow much quicker than large ones; moving from £10 million to £50 million in revenue can be more achievable than £1 billion to £5 billion
• Asymmetric upside — even a modest position in a successful penny stock can deliver life-changing returns, though such outcomes are rare and shouldn’t form your core strategy
• Diversification benefit — penny stocks provide exposure to sectors and niches absent from FTSE 100 or 250 companies, such as biotech or emerging tech
• Accessible positioning — investors can build meaningful positions with modest capital, enabling smaller portfolios to take strategic moves not possible in higher-priced shares

Cons of penny stocks

• Higher failure risk — smaller companies have higher bankruptcy rates due to limited revenue diversification and smaller cash reserves, leaving them vulnerable to lost contracts, downturns and market shocks.
• Operational fragility — their small size makes them more exposed to competitive threats, regulatory changes and shifting market conditions that larger companies can more easily absorb
• Unproven businesses — many penny stock firms lack profitability or even revenue, meaning investors are betting on a business plan rather than a proven track record
• Management inexperience — leadership teams may have limited experience scaling operations, and their strategies can falter when tested by real-world market pressures
• Market manipulation risk — low trading volumes make penny stocks prone to “pump and dump” schemes and frequent share dilution as companies raise capital, eroding shareholder value
• Patience required — penny stock investing often demands years for strategies to bear fruit, testing the resolve of even long-term investors

Risk management for penny stocks

Because penny stocks are particularly volatile, you'll need a comprehensive risk management strategy that goes beyond what might suffice for larger, more liquid stocks.

Stop-loss orders

A stop order sets the condition for a position to be closed when the market price moves below a certain point. If the market price moves toward a less favorable level, the stop will be triggered and your position will be closed to prevent further losses. Normal stops are free to set but may be subject to slippage in fast-moving markets, meaning you might exit at a worse price than you specified.

Guaranteed stops incur a fee if triggered but protect against slippage, including price gaps that can occur overnight or during trading halts.

When using stops with penny stocks, you must account for their volatility. Setting stops too tight will likely result in being stopped out prematurely during normal price fluctuations, forcing you to watch the stock recover after you've exited.

Wide spreads may also mean stops execute at significantly worse prices than expected, particularly with guaranteed stops. 

Limit orders

You could also set limit orders, which will open a position at a price that is more favorable than the current market price. This approach is particularly useful for penny stocks where spreads are wide, prices can gap significantly between trading sessions, and you want to buy dips without constant monitoring.

Limit orders ensure you never pay more than you intended and can help you capitalise on temporary weakness in otherwise strong companies.

Position limits

Setting maximum loss limits per position, for example, deciding that no more than 5% of your portfolio can be at risk on any single trade. Establish overall exposure limits across all penny stock positions combined, ensuring this high-risk portion of your portfolio remains at an appropriate level.

These rules prevent emotional decision-making during periods of stress and ensure that no single mistake can derail your entire investment plan.

Regular reviews

Review your penny stock holdings regularly rather than buying and forgetting. Earnings releases or trading updates provide natural checkpoints to reassess whether your investment thesis remains valid.

Changes in management or strategy should trigger immediate reviews, as should any deterioration in financial metrics like cash burn rates, margins or revenue growth.

Sometimes the best risk management decision is exiting a position because you've identified better opportunities elsewhere, even if the current holding hasn't technically failed.

Famous penny stock stories

Success stories include:

1. ASOS listed on AIM in 2001 at around 20p and grew to over £70 at its peak as it became a leading online fashion retailer, delivering returns of over 35,000% to early investors. Though the company has since declined significantly from those highs, early investors who held through the growth phase achieved life-changing returns.
2. Boohoo Group represents another AIM fashion success story. The company listed in 2014 at 50p and reached peaks above £4 before recent challenges, rewarding early investors who recognized the shift toward online fast fashion. 
3. Frontier Developments, a gaming company, listed on AIM at 45p in 2013 and reached over £30 at its peak. The company successfully developed and monetised popular gaming franchises, showing how technology companies can thrive as penny stocks before growing into substantial businesses.

Cautionary tales:

1. Patisserie Valerie appeared to be a successful café chain with a proven business model until accounting fraud was discovered in 2019, leading to administration and completely wiping out shareholders. The scandal demonstrated how even apparently established businesses can harbour hidden problems that destroy shareholder value overnight.
2. Kier Group, once a £20+ stock with a long operating history, fell to penny stock status below £1 due to crushing debt problems and issues with major contracts. The decline illustrated how even companies that seem stable can deteriorate rapidly when problems compound.
3. Imaginatron fell from £7 to under 10p amid serious questions over its accounting practices and business model. Investors who bought into the story at higher prices lost nearly everything, while the company's spectacular collapse raised broader questions about due diligence and market oversight.

These examples illustrate both the extraordinary potential and the severe perils of penny stock investing.

Penny stocks summed up

• Definition and trading venues — penny stocks are shares of smaller companies priced under £1 in the UK, typically traded on AIM or the LSE Main Market, each with differing regulation and investor protection
• High volatility and risk — low liquidity and limited company information make these stocks highly volatile, with major risks including business failure, dilution, and manipulation
• Due diligence is essential — success depends on deep research into financials and business models while watching for red flags such as persistent losses, serial fundraisings and pump-and-dump schemes
• Long-term mindset — success in penny stocks requires patience, disciplined management, and time for solid companies to grow rather than chasing short-term price spikes.