Penny Stock Investing Guide 101
Penny stocks are alluring to investors because of the possibility of considerable growth. This group of securities is much more speculative, making high percentage returns possible where they are unlikely with established, blue-chip companies. Where there is potential for growth, there is also potential for major losses. While every company was a start-up at one time, you could lose money looking for the next Intel (INTC) or Microsoft (MSFT).
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Definition
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Penny stocks are defined by their price-per-share, market capitalization and the exchange the stock trades on. These are typically small companies whose stock is not very liquid, considered highly speculative and traded on the over-the-counter bulletin board, pink sheets and foreign securities exchanges. The Security and Exchange Commission defines a penny stock as a stock that trades for less than five-dollars, or even for pennies. Others consider any stock that does not trade on the major market exchanges as a penny stock.
Exchanges
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The Over-the-Counter Bulletin Board is an electronic trading system regulated by the SEC and showing real-time quotes and volume information. It is a common exchange for penny stocks. Even though the National Association of Securities Dealers, Inc. oversees the OTCBB and companies are required to file financial reports to maintain their status on the OTCBB, it is not part of the Nasdaq Exchange.
The Pink OTC market operates Pink Quote, an electronic system that displays trading information for OTC securities. Companies trading in the Pink OTC are higher risk than other markets because they typically do not meet the minimum listing requirements for other exchanges. Stocks found on the Pink OTC are not required to file financial reports to the SEC, making it difficult to find reliable financial information.
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Attraction
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The lure of investing in penny stocks is the idea of being able to own more stock in a company for less money, creating an opportunity for huge growth. If a stock that is trading at 20 cents rises by a dime, you have made 50 percent on your investment. Sirius XM Radio, Inc. (SIRI) was trading at 11 cents at the beginning of 2009, after many investors sold the stock on the news of the Sirius-XM Radio merger. If you had bought Sirius in January of 2009, you would have made 475 percent on your investment by February 2010.
Risk
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The speculative nature of penny stocks contributes to the attraction as well as the risk. Penny stocks are inherently riskier than large-cap or blue-chip stocks because of the limited information on company operations and finances, unproven management or products, limited liquidity of the stock and lack of historical and technical information on the stock. There are also no minimum SEC requirements for them to remain on certain exchanges like the Pink OTC. The combination of these factors make it difficult to analyze the company either through technical or fundamental analysis, which can lead investors to fall prey to false or misleading information.
Expert Insight
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When researching a penny stock, be on the alert for bias or false opinions, and use only research that you know to be true. John Stark, Chief of the Office of Internet Enforcement at the SEC told Bankrate.com, "Take the same approach to choosing a stock that you would take in choosing a heart surgeon. Talk only to people you trust."
Penny stock investors can easily fall victim to a fraudulent investment strategy commonly known as the "Pump and Dump". These scams involve the overly-optimistic enthusiasm for a penny stock or a penny stock newsletter. Because penny stocks typically trade so infrequently, any sudden buying by investors will dramatically increase the price. The source of the fraudulent information will sell the stock as the price rises. This "dumping" of shares will then cause the stock price to fall dramatically. According to Bankrate.com, investors are rarely fast enough to recoup their initial investment.
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