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What is a Penny Stock?

Investment is a risk fraught business, and it takes a lion’s heart to bring oneself up to invest in some obscure penny stock about which very little information is made available to the public. Read to learn what a penny stock is and how you can invest in them.

With high risks, comes high returns. The lure of disproportionate profits from a meager investment (penny stocks cost less) is not something everybody will pass up. A penny stock is a stock that has low value, is traded in low volume and is relatively illiquid. Despite the name, penny stocks typically trade under $1 to $5 per share.

Origin of a Penny Stock

Small businesses having revenues and float less than $25 million, can register with the SEC their securities to be sold through an offering using Form SB-2.  Unlike the elaborate S-1 filing, companies need not divulge detailed information regarding their business, while they can also leave out summary data and also get away with providing less detailed financial statements. Shares of companies, which no longer have active operations, called the shell companies, continue to trade over the counter and such stocks are usually penny stocks.

When a company wants to raise capital by offering equity, it can opt to reverse merge with a shell company and in the process of avoid the tedium of even registering a SB-2 statement. Once a stock is delisted from a main exchange after failing to meet the standards for continued listing for a period of 30 days, it is given 180 days to regain compliance, if the violation is with respect to the $1 minimum stock price. The company can schedule a hearing with the exchange.

If the issue is not resolved, then the delisting procedure begins, post which it can opt to list its shares on the OTC. Once high-flying stocks of companies file for bankruptcy may now become a pale shadow of its old self. By that time, due to all the negativity, the stock would have become a penny stock. Such stocks will trade with a four-letter ticker, Q added as the fourth letter.

Where are Penny Stocks Traded?

The instances of penny stocks trading on the main exchanges such as the NASDAQ and the NYSE, are few and far between. As an investor protection measure, the main exchanges have something called the minimum listing standards, which the companies wanting to be listed on an exchange should conform to.

One of the criteria for qualifying to be listed on the NYSE or NASDAQ, is the minimum bid price, which should be $4 at the time of listing. That said, the NASDAQ allows listing of securities, which have closing prices of $3 and $2, while also satisfying a few other criteria. For continued listed on the main exchanges, the stock should trade above $1.

The NYSE delists a share if it traded below $1 for 30 consecutive days. Given the difficulty involved in getting their shares listed on the main exchanges, most companies with penny stocks list their shares on the Over-The-Counter Bulletin Board, or OTCBB, or the Pink Sheets.

The OTCBB is an interdealer quotation system operating under the purview of the Financial Industry Regulatory Authority, or FINRA, and it does not impose any quantitative minimums on sales or assets. The companies traded on the OTCBB are regulated loosely by the FINRA as well as the SEC. Meanwhile, the least regulated of the all is the Pink Sheet, which is a stock quotation service. The companies traded on the Pink Sheet need not file with the SEC and divulge any financial information to investors.

Why Do People Trade Penny Stocks?

The attraction in penny stocks is their low value. The per-share value is very cheap, allowing people to accumulate large volumes of shares. These stocks also have the potential to appreciate rapidly, generating huge returns in a relatively short time.

Why are Penny Stocks Risky?

Penny stocks, being thinly traded, are targeted by stock market manipulators, who purchase these stocks in lump and artificially inflate the stock price through the spreading of false and misleading information. Once the price rises notably, they liquidate their holdings and pocket the returns, which are usually abnormal and excessive.

This illegitimate strategy is called a pump and dump scheme and has become rampant now due to the wide-spread adoption of the Internet and personal communication devices. You only have to claim to possess some insider information about impending positive news through e-mail blasts, newsletters, chat rooms, stock message boards, etc.

Lack of liquidity is also a major risk. Unlike regular stocks, which trade with a good turnover in the market (millions of shares exchanging hands) and hence can be bought and sold easily, penny stocks are thinly traded. In the eventuality of a steep drop in the stock price and you want to sell the stock to minimize your losses, it is very difficult to find a matching buyer.

Regulations Covering Penny Stocks

Broker-dealers dealing with penny stocks are mandated by Congress to comply with the requirements of Section 15(h) of the SEC Act of 1934 and the rules under it and also the rules of the FINRA. These intermediaries should:

  • Approve the customer for the transaction and receive from the customer a written agreement to the transaction
  • Provide details of the risks related to investing in penny stocks
  • Disclose to the customer the current market quotation
  • Disclose to the customer the amount of compensation the firm and its broker will receive for the trade.
  • Send to its customer monthly account statements showing the market value of each penny stock held in the customer’s account.

How to Protect Yourself when Trading Penny Stocks

Beginners may be well advised to practice paper trading, which does not involve money. This can be done by making imaginary investing in a portfolio of penny stocks and make note of the trades in a paper. Once this practiced for a few months and one gains confidence, then he/she will be set to take a headlong plunge.

It always pays to be skeptical when researching this type of investment. While choosing penny stocks, look for the stocks of companies, which have been in the business for a reasonable length of time. Promoter holdings should be at least 30-40 percent, which reflects their confidence in the company.

When you do your math with the company’s financial statements, care should be exercised in avoiding those companies, whose balance sheet is right side heavy, meaning the liabilities are more than the assets. Don’t rely on mailers and newsletters, rather look for companies which are profitable and have the roadmap to achieve strong profit growth consistently. It is advisable to go with stocks that have track record of having fairly decent volumes (say at least 10,000 shares per day) Greed could land you in trouble.

Once you make a return that meets your profit objective, sell and steer clear of the investment, rather than wait for staggering gains. Shorting should be avoided when trading in penny stocks. In the eventuality of a short squeeze, you may not find stocks to square up your position, given the illiquidity associated with penny stocks. All said and done, penny stocks are not for the faint of heart. Astute, street smart investors, who have done their homework thoroughly by researching well can play this game of high return-high risk to their advantage. Otherwise, one stands to risk losing all of their investment.

Final Thoughts

If you’re ready to start trading penny stocks, you should check out Benzinga’s list of the best penny stocks and our favorite penny stock brokers.