Penny stocks are those securities that usually trade for comparatively lower prices, off of the big stock exchanges, and with smaller market capitalizations. Many analysts and investors look at these securities as higher in risk and extremely speculative. This is because they feature significant bid and ask spreads, less liquidity, smaller followings, and lesser capitalization and disclosure requirements. Many of these smaller stocks trade on the pink sheets or OTC Bulletin Board in what is known as the “over the counter market.”
Penny stocks used to be those which traded for under a dollar, but thanks to the SEC this is no longer the case. The SEC altered the definition so that all stock shares which trade for less than $5 are now considered to be a penny stock. These companies have fewer listing requirements, regulations, and filings which govern them.
It is important to remember that penny stocks best suit investors who can stand more risk. They come with greater amounts of volatility which can lead to steep losses or possibly greater returns. The lower volumes and greater amounts of risk are why the moves in these stocks can be staggering. These companies struggle with fewer resources and less cash, but sometimes achieve breakthroughs that can catapult their share prices higher. It is safer to trade or invest in penny stocks which are listed on the NASDAQ or the AMEX American Stock Exchange because these exchanges more vigorously regulate their constituent companies.
Four factors make these micro cap stocks so much riskier than traditional blue chip stocks. The information which the public has access to is usually lacking. It is harder to make well informed decisions on companies that do not provide sufficient information. Other information that is offered on such micro cap stocks can come from less than reputable sources.
Another feature that makes penny stocks so risky is that they do not have a common set of minimum standards. Neither the pink sheets nor the OTCBB require these companies to live up to minimum requirements to stay listed. They will have to file certain documents in a timely manner with the OTCBB, but not with the pink sheets. These standards traditionally offer a safety cushion that helps to protect investors. They are a benchmark for other smaller companies to achieve.
A third difficulty with these micro cap stocks is they lack history. A great number of such companies could be nearing bankruptcy or recently founded. This means that their track records are either non existent or poor at best. A lack of historical data compounds the difficulty of assessing a company’s future and their stock’s near and long term possibilities.
A final danger with penny stocks is their lack of liquidity. This creates two problems. An investor may not be able to sell out of the stock at an acceptable price. With low liquidity, there may be no buyer available at any price. Lower liquidity also leads to the possibility for traders to manipulate the prices of the stocks themselves. They can purchase enormous quantities of the issue, promote it themselves, and then sell it at higher prices to other investors who become stuck with it. This is called a pump and dump strategy.