What is a Penny Stock?
A penny stock is a common share of a small public company that is traded at a low price. The specific definitions of penny stocks may vary among countries. For example, in the United States, the stocks that are traded at a price less than $5 are considered penny stocks, while in the United Kingdom, penny stocks are only the stocks that are priced below £1.
Penny stocks are usually classified as microcap stocks with a market capitalization of less than $250 million or $300 million.
The majority of penny stocks are traded over-the-counter. However, some penny stocks can be traded on the big stock exchanges such as NASDAQ or the New York Stock Exchange.
U.S. SEC Definition of Penny Stocks
The U.S. Securities and Exchange Commission (SEC) provides its own specific definition of a penny stock. The SEC determines the following features of the stocks:
- Shares issued by a small company that are traded at a price below $5 per share. The penny stocks can also include the shares of certain private companies with no active trading market.
- Shares are usually traded over-the-counter such as on the OTC Bulletin Board or OTC Link LLC but can also be traded on the securities exchanges, including foreign securities exchanges.
- The shares are extremely illiquid.
- It can be difficult to price the penny stocks since the quotations for the shares cannot be easily obtained.
Penny Stocks as Investments
Similar to other types of shares, penny stocks can be used as an investment vehicle. However, a potential investor must be careful with such investments. The stocks are inherently speculative due to their high volatility and low liquidity.
In addition, the stocks are frequently used in fraudulent activities. For example, they are subject to the pump and dump schemes, and their prices are manipulated by the stock promoters.
A potential investor must be aware of the following characteristics of penny stocks that make them extremely risky investments:
1. Low liquidity
Since many of the penny stocks are traded over-the-counter, the liquidity of the stocks is low. An investor may not always be able to sell the shares at the right time. Also, the low liquidity results in low trading volumes of the penny stocks. Thus, even small transactions can cause large swings in the price of the shares.
2. Limited historical information
Most of the penny stocks are stocks of relatively young companies with the limited historical information. The companies generally lack a proven track record regarding operations, products, assets, or revenues. Therefore, investing in such companies are extremely risky.
3. Lack of public information
The microcap companies that issue the penny stocks are not required to file reports with the regulatory authorities (e.g., SEC). In addition, the penny stocks are not covered by professional stock analysts from designated financial institutions. Therefore, potential investors may not find sufficient resources to make an informed investment decision.
4. No minimum listing requirements
Since the penny stocks are primarily traded over-the-counter, the companies that issue these stocks are not required to meet certain minimum requirements for the listing.
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