What is a penny stock? The answer depends on who you ask.
The conventional wisdom is any common stock trading for less than five dollars a share, and is not listed on an exchange (meaning it trades over the counter).
Others define penny stocks as any stock that isn’t listed on one of the major exchanges, which includes virtually any low-priced, thinly capitalized company. Yet some of those trade in the millions of shares per day, meaning any definition is interpretive and subject to the context of the user.
Penny stocks are also known as micro-caps, small caps or nano caps, these terms being used interchangeably. And while the SEC defines a penny stock as being less than $5 per share, the more common street application of the term refers most often to those shares trading at less than $1 per share.
Low Price, Big Risk
Buying penny stocks presents unique risks, since often these smaller companies are hard to research and even harder to analyze. Investors are subject to scammers, who prey on individuals using thinly-based short-term estimates that, behind the scenes, are nothing more than “pump and dump” schemes. And when that happens, nobody makes money other than the scammer.
Why is anyone buying penny stocks?
Leverage is one reason – you can purchase more shares per dollar than with other stocks, and if upside movement occurs this means larger returns. However, since penny stocks often see their underlying companies go out of business, the risks here are significant.
Liquidity is also an issue. Penny stocks can be difficult to trade, since trading volume is often extremely low. Bids or offers to sell might sit idle for days. This makes penny stocks very difficult to short, which some investors consider because of the inherent downside volatility.
Trading Penny Stocks
Trading of these stocks is done through brokerage houses that choose to participate in these markets, which all houses do not. They are quoted on the OTCBB – Over The Counter Bulletin Board – and are more loosely regulated than SEC-regulated listed firms.
In essence, all they are required to do is make their filings on time, with minimum accounting standards, or few rules regarding notification upon a change in ownership shares (which can happen quickly and frequently), as well as any other material changes.
The biggest risk here, however, may be with scammers.
Because of the lack of information and thin trading volume, false information goes a long way. When it hits, the originating scammers have already taken a position in the stock, hoping the false information prompts buy-side pressure, thus driving it up. Then they’ll sell into that demand (avoiding liquidity issues) and get out before reality sets in and the prices sinks back to previous – or lower – levels.
Penny stocks are best left to insiders and affiliated investors who are familiar with the underlying company and its prospects. While price swings become an attractive arena for speculators, this is no place for the initiated.
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