A penny stock is a stock that trades at a low price without the major market exchange. Its market capitalization is small. Penny stocks are considered high risk and very speculative. This is due to their high bid-ask spreads, lack of liquidity, limited following, minimal capitalization, and disclosure. Penny stocks usually trade over the counter via pink sheets and OTC Bulletin Board.
Nowadays, penny stocks have evolved from stocks that used to trade for less than a dollar per share. The SEC has changed the definition to comprise all shares which trade below $5.
A majority of penny stocks do not trade on major market exchanges. But, there some big companies which trade below $5 per share on the major market exchanges like Nasdaq. Their size is based on market capitalization. For instance, Curis Inc. (CRIS) is a small biotechnology firm that trades on the Nasdaq. Hence, a penny stock is a small firm with speculative and highly illiquid shares. The firm is prone to fewer regulatory and filing standards. They are also prone to few listing requirements.
Points to Note About Penny Stock
These stocks are best suited for high-risk investors. They have a higher reward and risk. This is because penny stocks are very volatile. The high risk associated with penny stocks require that investors take precautions when investing in penny stocks. For instance, a shareholder should have a stop-loss order that is established before trading. It allows the investor to leave the trade if the market performs negatively.
Despite penny stocks having high rewards, investors should be realistic. An investor should not expect high returns in a week’s time. This is because shares take months or even years to mature.
Penny stocks are usually growing firms which lack enough money and resources. They are usually high-risk and the trading volumes are low.
For protection, trade in penny stocks which are listed on the Nasdaq or American Stock Exchange. Your protection will be ensured by the regulations that regulate these exchanges. Do not trade in penny stocks which are not listed. These include stocks listed on the pink sheet system in the OTC market.
Reasons why Penny Stocks are Risky
Lack of information Available to Public
In order to make a sound investment, you need information so as to make an informed decision. Micro-cap companies make information hard to get. Companies listed on the pink sheet system are not required to file with the SEC. They are hence not scrutinized publicly like stocks that file with the SEC.
No minimum standards
Stocks on the pink sheets and OTCBB need not fulfill a minimum standard requirement. When stocks fail to maintain themselves in the major exchanges, they move to the smaller exchanges. Minimum standards act as a benchmark for firms and cushion investors.
Lack of history
Micro-cap firms are usually either bankrupt or newly formed. They usually lack track records or have poor ones. Hence, it is hard to determine a stock’s potential.
When a stock is illiquid, you will not be able to sell the stock. You won’t find a buyer to buy the stock and you might have to lower the price to attract buyers.
As an investment, penny stocks are very risky. Hence you need to do a lot of due diligence before investing in them.