The Function of Penny Stocks
Investors can either reap dividends with the stock they hold, or wait until their shares increase in value and they sell them back on the stock market to win returns. For investors who follow the second strategy, careful management of stocks on a daily, sometimes second-by-second, basis is necessary -- or a high competent portfolio manager willing to be aggressive. This is where penny stocks can help savvy investors who want to realize large returns.
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Definition
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Penny stocks are simple common stock shares sold for a small price per share. The classic definition of a penny stock is any share priced under $1, but this definition has expanded. Some organizations consider anything less than $5 per share to count as a penny stock, while others set the limit to three dollars. The point is that penny stocks are not worth much per share, and investors can buy a large number of shares at one time without incurring large costs.
Companies
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Companies that offer penny stocks tend to be small cap, businesses that have a net worth of only a few million dollars at the most. These businesses are typically very young corporations that are just beginning to enter the public market with their IPO, or initial public offering. This is the company's first release of shares for sale on major exchanges. Because the company is still small and not well known, few investors are interested in its stock, so shares sell for only a small amount.
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Advantages
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Penny stocks have an innate uncertainty that investors must accept, but when used correctly they can yield dramatic profits. Small companies that start with penny stocks may suddenly grow and experience years of rapid success, driving its stock price up until shares that were once worth only a few cents on the public market are now worth $20 or $30, yielding amazing returns for the investors that first bought stock. This occurs when a corporation has a strong strategy and a good value offering, often involving a new process, product or technology.
Penny Stock Markets
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Strict guidelines exist for trading on large stock markets like the New York Stock Exchange. Companies must meet listing requirements that require a certain amount of stability and earning power in excess of $2 million. Companies with penny stocks can rarely meet these qualifications, so they must trade over the counter with alternative trading systems, such as the electronic OTC Bulletin Board or Pink Sheets. Since businesses trading in these smaller markets do not need to follow the same regulations as they would on the NYSE, investing in penny stocks through such small companies can come with high risk.
Considerations
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Penny stocks are inherently risky, because it is difficult to predict the future success of small companies. Many small corporations fail after their IPO if they even make it to a major market. Success is sometimes delayed for decades. Investors must conduct thorough investigation and be very wary of investing in penny stocks. When company analysis and information is so widely available, there is usually a reason stock is worth so little on the market.
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