Penny stocks are the securities of a small company. In general, it is a growing company with limited finances and sizes. Originally, penny stocks were traded for $1 or less per share. Now this limit is extended to $5 or less per share.
On the one hand, penny stocks give small companies an opportunity to grow and get investments. Also, they give investors a chance to increase their profits in a short period of time. On the other hand, these stocks contain a lot of risks for traders including the probability of fraud.
Sometimes a penny stock is traded on a large exchange. For example, Catalyst Pharmaceuticals Inc. (CPRX) is a big company, according to its market capitalization, but its shares were traded for less than $5 in 2020-2021 on the Nasdaq. Technically, it is a penny stock, but at the same time it’s not.
However, most transactions with penny shares happen through different over-the-counter (OTC) services. Stocks traded this way are called pink sheets. Trading in pink sheet securities is easier in terms of associated costs and requirements. However, it’s frequently viewed as highly speculative.
Characteristics of Penny Stocks
A penny stock is characterized by the following features:
- low price ($5 or less per share);
- low liquidity;
- wide bid-ask spread;
- high volatility;
- high risks.
Low price is explained by the company's size and instability. Low liquidity shows that it’s hard to sell this type of shares closely to the market price. Usually, there is a significant difference between the selling price and buying price. Also, these prices are quickly changed that shows a high level of volatility. Overall, penny stocks are frequently viewed as a risky investment because of these features. You should note that your risks will be even higher if you buy shares on margin. That means that you borrow money from a bank or broker in order to buy some shares.
Despite the risks, penny stocks gain attraction amongst traders due to the low price and potentially fast profit. However, this financial instrument is suitable for traders with a high tolerance for risk and wide economic experience. So, you should consider these risks and bonuses before making a decision.
Risks of investing in Penny Stocks
Beside aforementioned characteristics, penny stocks are considered as a risky investment because of a few more reasons.
Competition with the blue-chip stocks. A blue-chip is a well-known and well-established company. Any small company is hardly comparable with this giant. The latter builds its reputation and proves its credibility for a long time and through different market conditions. For example, Apple, Johnson & Johnson, and Coca-Cola are all well-known blue-chips. Their shares are higher in price, but so are their liquidity and reliability. Also, blue-chips often have enough resources to pay dividends to their shareholders.
Lack of history and information. Penny stocks refer to small companies, which can have little information about them presented to society. They can have a lack of experience in a business or lack of resources to create such kind of information. However, this information is important for traders. It helps them to analyze companies’ potential.
Lack of standards. Penny stocks are rarely presented on large exchanges, where companies meet certain requirements. When shares are traded over-the-counter, companies don’t have to follow these rules, and again leave the traders without the needed information.
Possibility of fraud. Penny stocks can be used as a way of deceiving investors. There are a few common deceits that can lure you into troubles. For instance, the pump and dump scheme is meant to attract as much attention to the penny stocks as possible, thereby unreasonably raising their price. That tendency helps perpetrators to sell their shares for a higher price and leaves other investors with overpriced securities in their hands. Also, one of the widespread fraud schemes is the creation of small shell companies. It’s not always easy to expose these companies because penny stocks trading has a lack of regulation.
A notable example of pumping the price of a penny stock happened in 2011 when the famous rapper 50 Cent dramatically increased the price of some penny shares due to his active promotion.
The Securities and Exchange Commission (SEC) makes a list of recommendations for identifying these shady schemes. However, there is no ironclad guarantee of investment protection.
In case you consider all the risks and feel ready to purchase penny shares, you should take some precautions in order to protect your capital. First, study the SEC recommendations for identifying fraud. Second, diversify your portfolio and decide which amount of money you’re ready to invest in penny stocks. Third, evaluate the price of the stop-loss order which prevents you from a significant monetary loss in case of unforeseen situations. This order will automatically sell your securities when they reach a certain price that you set beforehand.
The brokers involved in trading penny stocks have special rules for providing safe transactions. Let’s review some of these rules in particular:
- any transaction with penny shares must be approved by the broker-dealer;
- the broker must inform traders about the risks of these transactions and possible actions in cases of fraud;
- before completing the transaction the broker must show the traders current quotations of penny shares;
- every month the broker must give shareholders information on their account and show the current cost of their penny shares according to the market situation.
Penny stocks can be traded after-hours or, in other words, when exchanges are closed. A lot of market changes can happen during that time, that’s why it’s a good opportunity for risky traders to sell penny stocks for a higher price or purchase these shares for a lower price. Although it seems gainful, not many people choose to trade after-hours.
Creation and underwriting of Penny Stocks
Small companies need to increase their capital in order to grow. The stocks are the great opportunity for these companies to raise investments. Basically, that’s how penny stocks have been created.
First, a company needs to hire an underwriter specialized in securities offerings. As any other asset a penny stock is formed from an initial public offering (IPO). The company has to prepare required documents for the SEC. There are two forms for the registration – Regulation A and Regulation D. The first is made for regular registration and the latter is meant for companies that for some reasons can’t be registered. In addition, the company needs to provide the information about its finances and sales materials.
After the documentation approval first shares can be sold to the potential investors. Penny shares can be traded on or off exchanges. Some large exchanges such as Nasdaq have more strict requirements for an emitent. Consequently, penny stocks mostly are traded over-the-counter.
Small companies can make an extra offering for the secondary market in an attempt to get more investments.
Growth of Penny Stocks
It’s logical to assume that big companies were penny stocks at the start of their growth. However, there are not many examples of such significant growth. Most of the blue-chips have started from a higher price for a share than $1 or even $5.
A penny stock becomes a regular stock if a company increases its offerings on the market and starts to adhere to the SEC rules. Also, a company has to follow the SEC rules about business transparency if its market capitalization grows over $10 million or if it has more than 2,000 shareholders.