Penny Stocks Explained

Penny Stocks

A penny stock is commonly defined as a share of stock that trades for less than $5 per share. Some sell for just pennies, which is where the name “penny stocks” was derived. They can be found on all major stock exchanges. They are also traded over the counter on the OTC Bulletin Board (OTCBB) and Pink Sheets. The OTC Markets website excludes stocks from being declared a penny stock as follows: “This security is exempt from the definition of a Penny Stock under SEC under Rule 240.3a51-1 because it meets one of the following tests: 1) A price of over $5 per share, 2) the issuer has Average Revenue of at least $6 million for the last 3 years, or 3) the issuer has Net Tangible Assets in excess of $2 million if the issuer has been in continuous operations for at least 3 years or $5 million if less than 3 years.” For the long definition of a penny stock see the Electronic Code of Federal Regulations.

Here are some of the pros and cons of investing in penny stocks.

Penny Stocks are Risky

• High volatility and subject to large price swings. You could lose heavily if you try to sell at the wrong time.
• Small-capitalization, few owners, and small floats leave these penny stocks open to manipulation by stock promoters, a practice called pump and dump.
• Some penny stocks have little liquidity meaning there are fewer buyers and sellers and it may be difficult to sell them. Lack of liquidity often results in wide bid versus ask spreads, meaning you may have to unload your stocks at a much-reduced price.
• Since penny stocks offer new and small businesses a way to access public funding there may be a scarcity of reliable information available.
• Many penny stock companies are not making a profit. Some may have high debt loads. Some may be headed for bankruptcy.

Why Investors Buy Penny Stocks

• Penny stocks are inexpensive
• It is an easy way to start investing with a small amount of money.
• Penny stocks provide small companies access to capital. If they become successful, they can apply to get listed on a larger exchange, thus increasing liquidity and value to the investor.
• If a penny stock takes off, it can yield a very high rate of return on the shareholders’ investment.

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