Penny Stock

A stock with an extremely low value, usually issued by a very small and risky company.

Author: Ahmed Makki
Ahmed Makki
Ahmed Makki
I hold a BBA in Banking and Finance from LIU and a Graduate Diploma in Business Administration from Concordia university Canada. With 2+ years of experience in the asset management/financial services industry, I specialize as an AML Analyst. My skills include risk assessment, regulatory compliance, and financial analysis.
Reviewed By: Adin Lykken
Adin Lykken
Adin Lykken
Consulting | Private Equity

Currently, Adin is an associate at Berkshire Partners, an $16B middle-market private equity fund. Prior to joining Berkshire Partners, Adin worked for just over three years at The Boston Consulting Group as an associate and consultant and previously interned for the Federal Reserve Board and the U.S. Senate.

Adin graduated from Yale University, Magna Cum Claude, with a Bachelor of Arts Degree in Economics.

Last Updated:November 15, 2023

What Is A Penny Stock?

Penny Stocks are stocks that are usually traded for under $5 in the market. For OTC trades, there is no trading floor. Additionally, all quotations are generated digitally. In the past, stocks listed for less than $1 a share were called penny stocks. 

All shares trading for less than $5 now fall under the term, according to the U.S. Securities and Exchange Commission (SEC). 

The SEC is an independent federal body tasked with maintaining the fair and orderly operations of the securities markets while defending investors.

Since they typically belong to small businesses and are traded infrequently, they lack market liquidity or ready buyers. Investors can have difficulty locating a price that truly reflects the market due to the limited liquidity.

Investors risk losing their entire investment or a large portion of it.

Growing businesses with little funding and resources frequently offer their stocks on the market. 

They are best suited for investors with a high-risk tolerance because these are mostly small businesses.

Risks Associated With Penny Stocks

They typically have higher levels of volatility, which leads to higher potential rewards and, consequently, higher levels of inherent risk. Investors should use special caution given the increased risk levels involved with investing in penny stocks. 

An investor, for instance, should know what price level to exit a stock if the market moves in the opposite direction from the direction you intended and have a stop-loss order prepared before making a trade. 

Stop-loss orders specify a price limit above or below which the securities are automatically sold.

Although they offer the potential for huge gains, it's crucial to set reasonable expectations and realize they're high-risk investments with little liquidity. Some small enterprises do have access to public investment through it. 

These businesses might use this service as a stepping stone to enter a bigger market. Additionally, there is the possibility of tremendous upside because they sell at such modest costs. 

However, a few things make trading or investing in it more dangerous. Compared to more reputable businesses known as blue-chip stocks, penny securities are typically riskier. 

Blue chips stocks typically offer top-notch, extensively used goods and services. Blue-chip firms frequently have a track record of surviving recessions and continuing to make money in the face of challenging economic circumstances, which helps to explain their protracted history of steady and predictable growth.

Having adequate knowledge to make an informed selection when looking at various investment possibilities is crucial. 

Finding data on corporate performance for some penny stocks can be exceedingly challenging. When this is the case, it is possible that the information we have about such companies does not originate from reliable sources.

The "OB" suffix is added to the symbol of stocks trading on the OTCBB. The SEC receives financial statements from these businesses. However, listed companies on the pink sheets are exempt from SEC reporting requirements.

As a result, these companies are not subject to the same levels of oversight or regulation as the equities listed on the NYSE, Nasdaq, and other exchanges.

Penny Stocks: Liquidity & Issuance

Stocks with sporadic trading have little liquidity. As a result, it's probable that investors won't be able to sell the stock after the stock is bought. The investors would have to reduce their asking price until a different buyer finds it appealing. 

Additionally, low liquidity levels give some traders the chance to manipulate stock prices. The pump-and-dump strategy is a common trading fraud used to get investors to purchase a stock. 

The stock is bought in bulk, and then there is a time when the stock price is inflated or pumped up, and then the stocks are sold in huge quantities. 

The con artists sell their shares after other investors hurry to purchase the stock. Investors scramble to buy the stock as soon as the market learns there was no fundamental cause for it to climb.

Stock issuance is a popular strategy used by small businesses and startups to raise money for business expansion. Even if the procedure is drawn out, issuing stock is frequently one of the best and fastest ways for a fledgling business to get money. 

The initial public offering, or IPO, is a process of issuing penny stocks much like any other publicly traded stock. 

The corporation must first submit a registration statement to the SEC or file documentation proving that the offering is exempt from registration to be listed on the OTCBB.

It must also review local securities regulations in the states where it intends to offer the stock. Once approved, the business can start asking for orders from investors.

Risk & Barriers With Penny Stocks

There is a different market exchange where penny stocks are traded that is mostly uncontrolled by the Securities and Exchange Commission (Known as the OTCBB and Pink Sheets). Finding a genuine stock is quite unlikely. 

Most of these stocks are shell firms that experience momentum and price cycles due to their traders.

Even though practically nothing has happened to the company, it can increase by 300% daily and decrease by 90% the next. 

The following are the justifications for avoiding such stocks:

They have a very low daily volume compared to stocks listed on major exchanges like the S&P 500. This means that you might not have somebody to sell shares of a penny stock to in some situations. 

An average of a few thousand dollars worth of volume is traded daily. For speedy entry and exit, you want and occasionally need a stock to have strong liquidity, particularly where the price can suddenly drop.

You have been a victim of pumping and dumping if you have ever received an email or even an advertisement urging you to "buy" a penny stock right now. 

The goal is to inflate enthusiasm for the stock that the pumper already owns; as his followers believe the hype and considerably raise the stock's price, the pumper then sells his shares at a profit. 

In the meantime, those who fell for the hype will swiftly lose their money when the stock price declines and the rising momentum of the stock stalls.

Compared to equities listed on larger exchanges, they have little to no market capitalization. In the financial media, penny stocks are seldom ever discussed. 

There are typically no expert opinions, which should raise a huge red flag if these businesses were genuinely valuable.

Underwriting & Trading

Finally, the business has two options: it can either request to list the stock on a bigger exchange or use the over-the-counter market. 

Hiring an underwriter, typically a legal or investment banker with expertise in securities offerings, is the first stage, as with other new offerings. 

As per Regulation A of the Securities Act of 1933, the company's offering must be registered with the SEC or, if exempt, filed under Regulation D. 

If the company must register, Form 1-A, the registration statement, along with the company's financial statements and projected sales materials, must be filed with the SEC.

To preserve the public offering, the financial statements must remain open for public inspection, and timely reports must be sent to the SEC. 

Following SEC approval, sales information materials and disclosures, including a prospectus, may be used to request public orders for shares.

A registered offering can start trading in the secondary market by being listed on an exchange like the NYSE or Nasdaq or by trading over the counter once first orders are gathered and the stock is sold to investors. 

Due to the stringent criteria for listing on the bigger exchanges, many stocks end up trading OTC. After the initial public offering (IPO), corporations occasionally. 

Undertake subsequent secondary market offerings, diluting the current shares but allowing the company access to more investors and funding. 

Additionally, to keep investors informed and maintain their capacity to trade on the Over-the-Counter Bulletin Board, the companies must continue publicly releasing updated financial statements.

The SEC's Penny Stock Regulations

Investments in these stocks are regarded as being quite speculative. The SEC and the Financial Industry Regulatory Authority (FINRA) have guidelines to control their trading to protect investors. 

To be qualified to handle the stock transactions, brokers or dealers must adhere to Article 15(h) of the Securities Exchange Act and the related requirements:

  • Under 240.15g-9 of the Exchange Act, the broker or dealer is required to approve the investor's transaction and ensure that the investment is appropriate for their purchase.
  • A standardized disclosure document in accordance with 240.15g-2 must be given to the consumer. 
  • SEC booklet outlines the dangers of purchasing penny stocks, customer rights, and remedies for fraud. Brokers/dealers are required by Rule 240.15g-3 to disclose and verify the current quoted prices before consummating a penny stock transaction.
  • According to Rule 240.15g-4, the broker must disclose to the investor any cash received in exchange for facilitating the transaction.
  • According to rule 240.15g-6, brokers are required to send customers monthly account statements that include information about the number and identity of each penny stock held in their accounts.

After Hour Trading

Penny stock is vulnerable to volatility since it can be exchanged after hours since many important market movements can occur after markets close. 

Investors owning it may be able to sell shares for extremely high prices or buy shares for extremely low prices if they execute buy or sell trades after business hours. Even the finest stocks are vulnerable to poor reporting and little liquidity. 

Additionally, a seller may have trouble finding a buyer if it sees an after-hours increase. They rarely trade, which makes it challenging to buy and sell after hours. This is especially true after market hours.

Penny Stocks Scam

The SEC has struggled with penny stocks for a while now. That's because micro-cap stocks are an obvious target for scammers due to a lack of information and insufficient liquidity. 

Scams are widely used to rob investors of their money. The most typical ones are:

1. Recommendations with bias 

Some micro-cap firms pay people to promote their stock in publications, including newsletters, financial news sources, and social media. Spam emails may be sent to you to get you to buy a specific stock. 

All emails, messages, and suggestions ought to be treated with caution. It's always a negative investment if you see that people or businesses are getting paid for their services. 

Additionally, check to see that no press releases are misrepresented by anyone attempting to affect a stock's price.

2. Offshore Agents 

According to the SEC, companies selling stock to international investors outside of the United States are free from having their shares registered under Regulation S.

These businesses generally provide the stock at a discount to foreign brokers, who then resell it to American investors at a profit. 

These dishonest brokers will utilize high-pressure boiler room sales techniques to induce investors to acquire shares by cold-calling a list of possible investors with enough capital to purchase a specific stock and offering alluring information.

Authored & Researched by Ahmed Makki | Linkedin

Reviewed and Edited by Sakshi Uradi | LinkedIn

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