Introduction to Penny Stocks
Shares of small public companies that trade at low prices at the beginning, which might subsequently trade at higher prices, are called penny stocks. The other names are OTC Stocks, micro-cap, Nano-cap, or small-cap stocks. The U.S Securities Exchange Commission referred to penny stocks as a security issued by a small company that initially trades at less than $5 per share. (Source: Wikipedia). They are usually traded outside the major exchanges and typically traded over the counter (OTC) and are hence called OTC Stocks.
Though penny stocks have evolved from being traded at less than $1 per share, they include all the shares that trade below $5 as per the US SEC. sometimes the cut-off price may be $3. So to avoid all sorts of ambiguity, penny stocks are finally those which are traded on pink sheets or over-the-counter Bulletin Boards (OTCBB).
For example, Booking (NASDAQ: BKNG) (formerly known as Priceline.com) traded as low as $1.08 per share in 2001. BKNG now trades for about $1,965 per share.
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Advantages and Disadvantages
Below are the advantages and disadvantages of penny stock:
Advantages of Penny Stocks
- Though they are highly volatile, penny stocks yield exemplary rewards.
They have the potential to offer high growth in a short span and hence have become one of the popular choices among investors.
- Massive profits can be earned from small invested capital. As the name itself suggests, they start small. Subsequently, they have the capacity to make it big.
Disadvantages of Penny Stocks
- Low price in the market leads to low capitalization.
- Lower liquidity makes it difficult for the holders to cash out. When an investor wants to sell the shares, he might not be able to sell them immediately because of the lack of buyers available in the market.
- They are usually thinly traded.
- The lack of history of the company offering the penny stocks makes it difficult for the investor to choose his purchase as such companies would possess a poor track record or no record at all.
- Artificial inflation of share prices may lead to false statements regarding the company’s situation, which is also referred to as the “pump and dump” scheme, which is a form of fraud in microcap stocks, which is also called a supernova.
When the price is falsely and sufficiently inflated, the people who are ready to commit fraud will dump the shares and record instant profits.
- The lack of information available about penny stocks to the public makes it hard to make informed decisions about investments. There are few people who proclaim themselves to be experts in such matters and ask for lump-sum payments in exchange for knowledge or information about stocks. Investors should be aware and not fall into such traps.
Risks Associated with Penny Stocks
- Fraud risks are high. No minimum standards and compliance requirements make it easier for fraudsters to use penny stocks. Investors need to be attentive enough to understand the difference between impudent stock advertising, promotions, etc., and trustworthy equity research.
- Increase in white-collar crimes.
- It comes with high volatility. Though highly rewarded, penny stocks are highly volatile, and hence the investors need to be vigilant and must keep checking some warning signs as to when to invest/withdraw from the market.
- Investors must be aware of the possibility that they might lose their entire investment. Because the stocks are highly volatile, it is not possible to accurately predict the stock movements, and sometimes, it may lead to the entire investment amount being lost.
- They infrequently trade, which means investors have to face difficulties to sell them once they decide to sell. Also, there will arise some difficulties to obtain quotations for penny stocks.
For such reasons, they are considered to be speculative investments.
Other Important Points about Penny Stocks
It can be traded with OTC Bulletin Board, OTC Link LLC (previously known as Pink OTC Markets), securities exchanges including the foreign securities exchange, etc. It can also include securities of private companies with or without any active trading market.
The requirements of Section 15(h) of the Securities Exchange Act, 1934, and the rules there under must be complied by the broker-dealers of penny stocks, and if they do not, they will be prohibited to effect any transactions. The rules are as follows:
- The customer shall first agree to the transaction, and a written agreement to this effect must be made and shall be obtained from the customer;
- A disclosure document that reveals the risks of investing must be furnished to the customer;
- The current market quotation of the penny stocks should be provided to the customer; and
- Details regarding consideration to the firm and the broker for effecting the must be disclosed to the customer. Also, after the sale, the broker-dealer shall send to the customer the market values of the stocks in the monthly statements.
As we have learned above, penny stocks are those that trade at any value less than $5. They allow investing in small amounts and help to earn big amounts if the right one is found. They are highly volatile in nature, and because of that, there may be cases where the entire investment may be lost. Plus, a lot of scams exist. That means penny stocks are not for everyone. Extensive research has to be done before deciding to invest in such stocks.
This is a guide to Penny Stocks. Here we discuss the Advantages and Disadvantages along with the limitations and important points. You can also go through our other suggested articles to learn more.