In the U.S., a penny stock, also as a micro cap equity or small cap, refers to a share in a company which trades for less than $5.00.
While this is the official definition as used by the SEC, generally every full service or discount broker, and the vast majority of analysts and institutional investors, there are less formal criteria applied by the general public and most retail investors.
In other countries the term may be used differently, without reference to US institutions.
Some of these alternatives include
- a price per share being less than $1, and as low as fractions of one cent;
- a market cap of less than $50 million or less than $25 million;
- Trading on more obscure markets, such as the Pink sheets.
While such definitions are sometimes used by individuals and retail investors, the various and loose definitions enjoy no consensus or accuracy.
There are many limitations with the alternative definitions. For example, there are many companies trading for only a few cents with market capitalizations of hundreds of millions of dollars, or corporations trading on the Pink Sheets but having share prices of $50 or more.
Both negative and positive connotations surround penny stocks, micro caps, and low-priced shares.
Speculative investors are attracted to penny stocks because generally they
- are more volatile;
- make larger price moves in shorter time frames;
- have greater upside potential on a percentage basis;
- are easier to acquire with less initial investment.
More conservative traders usually shy from the penny stocks because
- they think the underlying companies are often less secure or fundamentally sound (e.g., no earnings or negative earnings, negative book values);
- they think many shares are too volatile, on both a price and percentage basis (what about google or sprint)
- they think the companies generally don’t pay dividends;
- they think they aren’t subject to the same reporting requirements as Blue Chip equities, if they are on the lower level exchanges.
The two sides to the investment philosophy ring true to the old axiom, “high risk, high reward.”
Newer investors are interested in hot penny stocks because of the possibility of rapid and significant gains. However, there are several risk factors for traders that go beyond simple issues and concerns with the operations of the company.
Stocks trading for less than $5 are considered by brokers to not be “option eligible”. Such securities are subject to higher trading commissions, much stricter levels for margin requirements, and usually cannot be used to borrow against. Generally, unless it is option eligible, the equity cannot be sold shorts.
Also, depending on the liquidity of the underlying shares, and the exchange that the company is listed on, it can be problematic to sell your position. In extreme cases, investors may encounter difficulty liquidating their positions even when the shares are on the rise. This sort of problem is mainly prevalent on the Pink Sheets market, and less common among more legitimate exchanges such as the Nasdag, OTC BULLETIN BOARD, or American Stock Exchange.
It is generally more difficult to find information of penny stock companies trading on the secondary markets. Often, a Pink Sheet company will be listed and traded, yet make no publicly accessible information regarding their financial position, the corporate fundamentals, or operational guidance.
Since many sub $5 companies are thinly traded, and especially those that trade for fractions of one cent, they are targets for price manipulation. For example, an individual or organization buys up hundreds of thousands, or even millions of shares, then uses web sites, faulty press releases, and e-mail blasts to drive interest to the company. Very often, faulty or misleading information is provided, resulting in investors buying shares in the underlying company. The increased demand pushes the price up, while the original individual or organization doing the “pumping” sells their holdings.
To find out more information about how to trade penny stocks, research your query via OTCBB, Yahoo Finance, ADVN or a simple Google search.
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