Penny Stocks Explained

16-02-2012 | By admin on 16-02-2012 | Category : News

What are penny stocks? Penny stocks are common shares of small public companies that trade at a low value. In the United States, the Securities and Exchange Commission (SEC) defines a penny stock as a stock that trades at less than $5 per share. According to Investopedia.com, the terms “penny stock” and “micro cap” can be used interchangeably. A micro-cap stock is a stock that is capitalized between $50 and $300 million.

The definitions for a penny stock can vary, with some setting the cut-off point at $3, while others define penny stocks as those selling for less than $1. Any stock that is trading on the pink sheets or over-the-counter bulletin board (OTCBB) is also considered to be a penny stock. In some countries outside the United States, penny stocks are called “cent stocks.” (“Penny Stocks,” 2012; Investopedia Staff, February 19, 2009).

The main thing to know about penny stocks is that they are extremely volatile. Four major factors make penny stocks more risky than blue chip stocks. First, it is much harder to find information on micro-capitalized stocks. Companies that are quoted via pink sheets are not required to file with the SEC, and thus are not as closely scrutinized as stocks that are quoted on the New York Stock Exchange or the NASDAQ. Also, much of the information available may not be credible (Investopedia Staff, February 19, 2009).

Secondly, there are no minimum standards for stocks on the OTCBB and pink sheets to remain on the exchange. Also, this is why stocks are sometimes listed on one of these exchanges. Further, when a company can no longer maintain its position on one of the major exchanges, it must move to one of the smaller exchanges.

Although the OTCBB requires companies to make timely filings with the SEC, the pink sheets have no such requirements. Many investors view minimum standards as being a necessary safety cushion when making investment decisions. Since penny stocks do not meet minimum standards, this makes them a more risky investment (Investopedia Staff, February 19, 2009).

Thirdly, Penny stocks and micro-cap stocks tend to have a lack of history behind them. Often, the companies behind these stocks are newly-formed, or may be approaching bankruptcy. Or, they have poor track records or none at all. The lack of historical information on penny stocks makes it difficult to determine the stock’s potential (Investopedia Staff, February 19, 2009).

Fourthly, penny stocks tend to lack liquidity. It may be difficult for traders to find buyers when they want to sell their shares. Also, the low liquidity of penny stocks makes them vulnerable to price manipulation, such as “pump-and-dump” schemes (Investopedia Staff, February 19, 2009).

Successfully trading in penny stocks can be very tricky. It is important to review the information at hand and weed-out any low-end or mediocre investment candidates. Make sure the company you are investing in has increasing revenues or the prospect of one day increasing them.

Try to determine who owns most of the shares—if they are held by insiders, then pay attention to the motivation of management. You also need to study trading volume, as a consistent volume is necessary to prevent possible downward selling pressure. Because of the volatility of penny stocks, traders need to have a plan of entry and also an exit plan, and stick with them. Having a plan will help traders secure gains and limit losses, to ensure that their investment portfolios keep growing (admin, October 28, 2011).

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