Penny Stock Definition
Penny Stock refers stocks of public companies that trade at a very low price, typically less than $5 per share and are highly illiquid. Usually, these stocks belong to small and newbie companies with a low market capitalization.
It isn’t easy to find a buyer quickly as they predominantly trade through over-the-counter transactions. However, some stocks also trade on exchanges like the NYSE.
- Penny stocks are stocks of companies that are small and have low market capitalization, often below $300 million. The shares trade at less than $5 and are highly prone to speculations.
- The stocks come with low liquidity because of predominant over-the-counter trading. However, some also trade on exchanges like the NYSE.
- Over the years, OTC market groups have emerged as the dominant OTC trading platform, allowing an easy electronic exchange.
- Financial Industry Regulatory Authority (FINRA) is the organ that regulates brokers-traders operating in the OTC market.
- Micro-cap and OTC stocks are deemed risky as many aren’t obligated to prepare and file their financial reports with the SEC. As such, they are prone to pump and dumps due to lack of credible information to rely on.
Understanding Penny Stocks
Penny stocks give an avenue to small companies to raise funds from the public. Many companies of humble means cannot afford to have a stunning debut on renowned stock exchanges. So instead, they trade as penny stocks through over-the-counterOver-the-counterOver the counter (OTC) is the process of stock trading for the companies that don't hold a place on formal exchange listings. The broker-dealer network facilitates such decentralized trading of derivatives, equity and debt instruments. (OTC) exchanges, while some make it to small exchanges and even reputed ones like NASDAQ.
As per the Securities and Exchange Commission (SEC), penny stocks typically have a share price of less than $5. The market capitalization is also very low, often below $300 million. Many are micro-cap stocksMicro-cap StocksStocks with a market capitalization of $50 million to $300 million are known as micro-caps. The market capitalization of such stocks is higher than that of nano-cap firms, but lower than that of small-cap, mid-cap, and large-cap companies. as they have a market capitalizationMarket CapitalizationMarket capitalization is the market value of a company’s outstanding shares. It is computed as the product of the total number of outstanding shares and the price of each share. between $50-$300 million.
Some examples of penny stocks that were in the news recently are J C Penney, SpectraScience, and Blue Sphere Corp. These companies had made headlines after a dramatic boom in their share prices.
People invest in penny stocks as it is easy to buy a large number of shares. Investors find it easier to spend $4000 if per share price is $1. If the stock price climbs to $2 per share, the investor can make $4000($8000-$4000). High priced shares don’t give this freedom. Moreover, some traders provide early hour access to certain stocks throwing an opportunity to score off market volatility.
Over the years, OTC market groups have emerged as the dominant OTC trading platform, allowing an easy electronic exchange. Penny stock trading has become simpler due to apps from companies like Robinhood, Fidelity, etc.
Financial Industry Regulatory Authority (FINRA) is the organ that regulates broker-traders operating in the OTC marketOTC MarketOTC markets are the markets where trading of financial securities such as commodities, currencies, stocks, and other non-financial trading instruments takes place over the counter (instead of a recognized stock exchange), directly between the two parties involved, with or without the help of private securities dealers.. However, OTC stocks and micro-cap shares are deemed risky. Many micro-cap stocks don’t file their financial reports with the SEC leaving little information about the company’s performance. It makes them prone to dangerous speculations.
Why are Penny Stocks Risky?
Recently, CNBC reported that Bank of America’s Merrill Lynch brokerage banned the purchase of penny stocks to protect the clients’ interests. So, what makes them risky? Let’s take a detailed look.
- Since many stocks are exempt from financial reportingFinancial ReportingFinancial Reporting is the process of disclosing all the relevant financial information of a business for a particular accounting period. These reports are used by the stakeholders (investors, creditors/ bankers, public, regulatory agencies, and government) to make investing and other relevant decisions. requirements, there is little to no information on them. Investors often remain ignorant regarding the firm’s profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance. due to an absence of credible sources to acquire data.
- Besides, it is difficult to gain insight on newbie stocks as hardly any details are available on the company website. Popular platforms do not feature mediocre stocks, keeping them in the shadows.
- Investment decisions are therefore weak as an investor’s source of company information gets restricted to brokers or dealers who are commissioned to sell off these shares. With lack of objective and reliable information, investors would hardly have a clue if a company is close to bankruptcy or is shutting its doors soon.
- Theese stocks are highly prone to speculations and volatility leading to pump and dumps. Pump and dump schemes plague OTC stocks with the SEC keeping a close watch to protect the investors. Offenders take advantage of lack of information and promote a mediocre company as the next big thing.
- Reports regarding the SEC punishing a pump and dump offender often swarm the web. For example, in 2014, the SEC had charged a penny stock company CEO for defrauding investors with false press releases. The company made $91,000 from the fraudulent act. Offenders use press releases or other promotional means to hype up a stock, leading investors to put their money in it.
- With more money getting pumped in, the stock price booms artificially and upon peak, offenders sell off their chunk. Large scale dumping of the shares lead to sharp price falls. It hardly ever taking off again due to absence of a real growth causing investors to incur a tremendous loss.
- Another reason that makes them risky is their vulnerability towards being delisted. They are always close to being delistedDelistedDelisting is the process of removing a security from a stock exchange so that it can no longer be traded on that market. It can occur for a variety of reasons, including non-compliance with listing rules or norms, mergers, or bankruptcy. when they trade on a stock exchangeStock ExchangeStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ.. If a stock falls below $1, they can be delisted from NASDAQ and NYSE.
- To prevent delisting, companies undertake reverse stock splitReverse Stock SplitReverse stock split refers to the process of boosting a company’s stock price by reducing the number of its outstanding shares. It is attained by combining some of the existing shares in the market and simultaneously raising their value in the same ratio.. It leaves investors with fractional sharesFractional SharesFractional share refers to just a part of equity stock which doesn't amount to a single stock unit. Such shares are acquired after stock splits, merger or acquisition, dividend reinvestments, capital gains and dollar-cost averaging. The shareholders cannot sell these stocks in the open market. or odd lots. Besides, not many firms bounce back when they struggle to keep their shares listed at a price as low as $1. A good number of them remain stagnant for years without showing any signs of growth.
- Lastly and most importantly, penny stocks are highly illiquid. It is often difficult to arrange buyers even if the share price has risen. They lack the ease with which investors can trade NASDAQ shares at any point of time. Hence, converting them to cash comes with a fair chance of losing the whole of investment in case no buyer turns up.
Penny Stock News
The latter half of 2020 saw the stock market bounce back from the pandemic induced losses of March. Micro-cap stocks were also caught in the momentum, with many firms’ witnessing their share price climbing up dramatically. Shortly after the GameStop’s unusual price boom, penny stock witnessed a similar frenzy when unknown stocks such as SpectraScience surged 633%.
Social media inflated the price of many small company shares. An average of 99 billion OTC stocks had exchanged hands in the first few weeks of February, as per Bloomberg. SpectraScience hadn’t file financial reports with the SEC in years. Resultantly, the SEC had to suspend its trading and several similar OTC stocks that were pumped up by the social media.
Since it is hard to find credible information on OTC stocks, investors look for reliable platforms. As a result, many articles are released from reliable platforms such as NASDAQ on the best penny stocks to buy, watch or invest in. For example, as per a list featured on NASDAQ’s website, penny stocks such as Boqii Holding, Tuniu Corporation, and Borr Drilling are the best buys of the latter half of 2021.
How to Invest in Penny Stocks Safely?
- As per the SEC, the salesperson and brokers are legally obligated to disclose certain terms of penny stock deals which investors must be aware of.
- For example, federal laws require the salesperson to disclose offer and bid on the stock, which are necessary to get an idea of expected profits. If a broker does not have a bid priceBid PriceBid Price is the highest amount that a buyer quotes against the “ask price” (quoted by a seller) to buy particular security, stock, or any financial instrument. , the investor will not be able to sell the shares.
- Additionally, brokers must reveal the compensation received from the company whose stock they are selling. The brokerage also needs to send investors a monthly account statement of all the penny accounts held under their name.
- One can get disciplinary action reports regarding a salesperson from FINRA. On issues with a salesperson, the SEC advices approaching a company’s compliance officer.
- Investors must rely only credible sources regarding the company related news to avoid falling prey to pump and dumpsPump And DumpsPump and dumps refer to the scam of raising the price of vulnerable stocks using misleading promotions and selling off the shares once their price booms. After voluminous selling and the hype wearing off, the share price dips sharply, leaving many investors in heavy loss. . They must also check the validity of claims from multiple sources.
- Any investment decision should come off after collecting as much information as possible. There are many reliable apps and authorized platforms that bring promising stocks to the limelight. It might still be better to invest in a such firm as it has drawn public attention which would require guarding its reputation.
An investor can make bulk purchases as penny stocks cost less than $5. If the price rises even by a dollar and the investors sell off their shares at the right time, there could be rich earnings. However, these stocks are prone to fraudulent speculations and heavy losses, requiring an investor to exercise extreme caution.
Investors can refer to reports featuring these stocks from credible sources to get an idea of best buys. For example, as per a list featured on NASDAQ’s website, Boqii Holding, Tuniu Corporation, and Borr Drilling are the best penny stocks to buy in the latter half of 2021.
Yes, they are highly risky as they are prone to volatility, pump and dumps, and the absence of readily available buyers. Moreover, small companies often exhibit stagnant growth leading to their delisting or disappearing into thin air, making investors prone to severe losses.
This article has been a guide to what is Penny Stock and its definition. Here we discuss the example of penny stock along with its advantages and disadvantages. You can learn more about equity research from the following articles –