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There is no single accepted definition of a penny stock. Some people refer to them as stocks that trade for less than $1, others set the cut off point at $3, while some deem a penny stock anything that trades below $5, so there are a variety of opinions as to what share price determines the penny stock. However, the Securities Exchange Commission (SEC) has defined penny stocks as low price stocks of small companies generally trading under $5. While penny stocks generally trade “over the counter,” they can also trade on U.S. securities exchanges such as the NYSE, AMEX or NASDAQ. Many can also trade on foreign exchanges such as Canada and Germany.
Penny stocks are a high risk / high reward undertaking and a large number of investors keep away from them, largely due to the fact that one could end up losing money due to amount of risk involved. But if investing prudently, one could make huge profits by investing in fundamentally strong penny stocks, as they can be bought for a few cents per share and ultimately sell for several dollars per share.
To summarize, the main characteristics of a penny stock are:
Penny stocks normally trade for less than $5 in the over-the-counter markets;
They are generally issued by small companies looking for funding to meet their initial expenses;
They follow a high risk / high return model;
If invested wisely, one could make huge profits by investing in penny stocks; and
On the downside, one could also end up losing their capital as penny stocks generally pose high risk.
Penny stocks became popular around the 1940-1950s when shares of uranium mining companies were bought and sold literally over the counter in a coffee shop in Salt Lake City. These unregulated markets suited the “wild west” spirit in the early days of the penny markets, and a large number of companies sprang up around that time promising investors huge returns if they invested in their penny stocks. By the 1980s, penny stock fraud began to take place primarily from Salt Lake City, Denver, Spokane and Boca Raton. Companies that were not backed by any assets, earnings or employees, began changing hands as investors were promised their pot of gold at the end of the rainbow. Several companies also came out with Initial Public Offerings (IPOs) at low prices so that they were saved the bother of filing information with the SEC. Though some of these stocks did go on to yield returns to their initial investors, most of them proved to be bogus shares, with no trace of the company after the IPO was completed.
Here is a closer look at the various advantages and disadvantages of trading penny stocks. The advantages of investing in penny stocks are:
Since they are low priced, you can buy a significant number of shares with the possibility of a very handsome return. For example, let us take a case where you plan to invest $1,000. If you invest this in a stock priced at $2 per share you could buy 500 shares, but if you invest it at a higher priced stock, say $50 per share you would only be able to buy 20 shares;
Many companies list their stocks at low prices on the Pink Sheets and the OTCBB as a stepping-stone, with the hope that later they’ll be able to get a listing on one of the national markets. As you can guess, once a stock moves to a national stock exchange its value is bound to increase; and
A low priced stock has the potential of posting impressive gains in the short run. For example, a $2 stock can trade to $4 within days, but a $100 stock rarely advances to $200 per share in the same period of time.
Here are some disadvantages of investing in penny stocks:
Since penny stocks generally have low daily trading volume, they can be difficult for the investor to enter and exit at a good price;
The difference between the bid and the ask price of penny stocks can be large, meaning you could need a greater percentage increase in stock price just to break even; and
There is sometimes little information publicly available on penny stocks since a large number of them are not required to file their financial information with the SEC. One would find very little analyst coverage on these stocks.
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