Penny Stocks and Shares Trading: What is a Penny Stock?

Penny stocks are traditionally identified as equities that trade at the low end of the ranges of prices found in the market, often less than a dollar or for "only pennies." The U.S. Securities and Exchange Commission currently considers the term "penny stock" to refer to "a security issued by a very small company that trades at less than US$5 per share."^[1]

Equities of companies that have a low market capitalisation, or "micro-caps," have also been considered as "penny stocks." These can include stocks with a market capitalisation of under US$300 million. Also, equities of some private companies with no active trading have been considered penny stocks.^[1]

Bargain Prices

Some companies that are just starting out may take years to reach elevated share prices or pay out attractive dividends, and investors can't always be certain of the timetable for their investments in these shares to become profitable. However, one of the strong attractions of penny stocks is that investors with little capital can buy large volumes of shares at low prices, and thus see a profit if the shares show large price movements.

For example, a small investor could buy 10,000 shares of a stock at 20 cents per share for US$2,000. If the share price moves to 30 cents per share, the investment would then be worth US$3,000, and the investor could sell the shares for a profit of US$1,000 less transaction costs such as broker commissions and taxes. If the share instead dropped to 10 cents, and the investor sold the investment, the loss would be $1,000. ^[2]

Where To Find Penny Stocks

Generally, penny stocks are traded on over-the-counter markets (OTCs). They are less formal and less regulated off-exchange markets where investors can find less well-known and potentially lucrative securities that aren't available on major exchanges. In the U.S., OTCs are managed by the Financial Industry Regulatory Authority (Finra) and the OTC Markets Group, Inc.

Some penny stocks may also be found on regular exchanges. OTCs, however, specialise in penny-stock trading on platforms such as Finra's OTC Bulletin Board and OTC Link LLC. The OTC Bulletin Board is accessible to securities dealers, and the OTC Link operates two marketplaces where penny stocks can be traded: the OTCQB and the OTC Pink. OTCs are restricted to brokers and dealers, but most online brokerages can execute trades of securities listed on them.^[3]

Regulation

Unless they are traded on major exchanges, companies listing penny stocks are subject to fewer regulatory and financial reporting rules than other equities. Under the OTCBB's eligibility rule, companies that want to have their securities quoted on the OTCBB must file current financial reports with the SEC, or with their banking or insurance regulators. OTC Link does not require companies quoted on its systems to meet any listing requirements.

However, those that are current in their reporting to the SEC or a U.S. bank, thrift or insurance regulator can be listed on its OTCQB markets. The remainder that do not meet any minimum financial standards or regular reporting requirements are listed on the OTC Pink marketplace.^[4]

A Risky Game

While there are legitimate companies traded as penny stocks, it may be very difficult for investors to find current or reliable information about those companies as they tend to be closely held or extremely small. Additionally, penny stocks rarely pay dividends. Based on those characteristics, penny stock trading is often considered a gamble.^[5]

Thin Liquidity

Penny stocks may also trade infrequently, making them illiquid and difficult for investors to buy or sell without affecting the quoted price. The liquidation of a position in such securities may not be possible within a short or reasonable period of time.
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Fraud Schemes

Penny stocks have also frequently been made the instruments of fraud schemes. Among the most common of these is the so-called "pump and dump" scheme, where the owners or major inside shareholders artificially inflate the price of shares to drive up investor interest and trading in the stock, only to sell it off, take profits and let the share price fall precipitously. These stocks are frequently "marketed" with professional advertising or by brokers offering tips, but the companies involved may not actually have a promising outlook or could in fact be merely shells of operations that are dormant.

Another, similar scam is known as "short and distort." In this type of scheme, the operators short-sell a stock and then spread negative rumors about the company in order to drive down its share price and take a profit.^[7]

Summary

Penny stocks are often considered too risky for novice trader. Extreme caution should always be taken when considering penny stocks.