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The Basics of Penny Stocks

Penny stocks, also known as unlisted  or over-the-counter stocks, are very low-priced stocks that generally trade for less than $5 per share. They are usually traded in the Over-the-Counter market, which includes the OTC Bulletin Board (OTCBB) and the Pink Sheets, which is a quotation service that collects and publishes real-time market maker quotes for OTC securities. Also commonly called small- or micro-cap stocks, they are highly speculative in nature and known to be extremely risky.

A small cap, or capitalization, implies that the company does not have many shareholders. A company’s capitalization is computed by multiplying its price per share of stock by the number of outstanding shares, arriving at a total dollar value of the company’s shares at a particular time. Having few stockholders also adds to the illiquidity and volatility of the stock. Because the volumes traded in the market are so low, even small changes in the stock’s supply and demand can result in wild fluctuations of its share prices.
Generally, penny stocks do not have to meet the same Securities and Exchange Commission (SEC) qualifications that are applied to regular stocks. Medium- and large cap companies whose stock offerings trade on major exchanges must meet basic requirements with regard to minimum- and net assets, market capitalization, and minimum number of shareholders. Micro-cap stocks have no such minimum listing requirements on the OTCBB or the Pink Sheets.

There are a number of other risks associated with micro-cap stocks. For example, there is usually a lack of knowledge about them due to the fact that they are not required to register with the SEC and, as such, are less regulated and monitored than other stocks which trade on the New York Stock Exchange or the National Association of Securities Dealers Automated Quotations (NASDAQ) systems. Many times, the information which is available can be unreliable. Because of this lack of regulation, many scams involving penny stocks have been perpetrated on investors taken in by the lure of quick profits. Also, most companies that are considered penny stocks have no credible track record or strong financial status upon which to rely. (This is not always true, however – numerous large corporations have been traded as penny stocks due to their being weakened by major financial setbacks.) And, as stated earlier, micro-cap stocks -- unlike regular stocks -- tend to be highly illiquid, making their disposition even more difficult.

Although the danger, and even likelihood, of losing one’s investment with penny stocks is quite real, it must be stated that there is more to their story. It is a fact, for instance, that for the last six years penny stocks have outperformed large stocks. There are a number of investors who have made millions in the small-cap market, though they are far and few between. So, what is the continued attraction of penny stocks? To sum it up in one word: greed. The promises of high yield and quick riches which are used to tout penny stock offerings are attractive to many investors. The prudent investor must always remember, however, to never buy a stock without paying attention to the business that’s being bought into, and to never completely disregard his or her common sense.

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