What Is the Definition of Penny Stocks?
We'd all like to spot the stock that will become the next Microsoft and buy in while it's still cheap. The chance of doing just that explains the appeal of the low-priced securities called penny stocks. Of course very few of these stocks will ever become a corporate giant, but some do quite well. On the other hand, many fail. Here's what you need to know about penny stocks.
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Identification
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There is no single definition of penny stock. In the United States the Securities and Exchange Commission (SEC) uses the term "penny stock" to refer to small companies whose shares trade for under $5 per share and are usually thinly traded (have a low volume of shares traded). In the United Kingdom, the definition is a stock that trades for less than 1 pound per share and has a total market capitalization of under 100 million pounds. Some investors are more restrictive and only consider stocks trading for less than $1 per share to be penny stocks.
Types
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Some people in the United States categorize penny stocks based on size as well as price. A microcap stock is a penny stock in which the company has a total market capitalization of $50 to $500 million dollars and a nanocap stock has a market capitalization of under $50 million.
Features
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Most penny stocks are traded over-the-counter (OTC) and are listed by quotation services commonly called "pink sheets." Companies whose stock is traded in this manner are not usually required to file with the SEC and are not subject to the stringent standards of exchanges like the New York Stock Exchange. Volume is usually low except when a particular stock attracts speculators' attention. The low trading volume limits the stock's liquidity and can make it difficult to sell. In addition the combination of speculation and low liquidity can lead to wide price swings (volatility).
Function
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Market behavior for penny stocks is often much different than for stocks traded on stock exchanges. This creates issues buyers of penny stocks need to keep in mind. Because trading is subject to little regulation and companies are often new, it may be difficult to gather the information one needs to properly evaluate the stock. Another problem is the possibility of stock manipulation and fraud. The low liquidity and speculative atmosphere surrounding penny stocks can make them a magnet for scam artists. The key to protecting yourself is to have information on the stock that comes from reliable sources.
Considerations
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Penny stocks are a high risk speculative investment. Traders in penny stocks are looking for large returns with small investments and are willing to take those risks. Many of the companies traded are new and do offer real opportunities. However, the beginner should realize that a large percentage of these firms will fail and the stock will lose all of its value. It is critically important to research any penny stock thoroughly before investing any money so you understand the firm's potential and whether it has sound management and the resources and position to grow and be profitable. Brokers and financial consultants can help you find reliable information. Avoid relying on websites or promotional emails and invest only in stocks after you have verified your information about a penny stock.
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