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What Is Penny Stock Investing?

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Different people have different definitions of what a penny stock is, but most define it as a stock that is trading for less than one dollar.

Others consider a true penny stock to be a stock worth less than one dollar that’s trading on a major stock exchange. It all boils down to who you ask. It really does not matter that a stock is traded on a major exchange because the defining element of a penny stock is the price of the stock and not the exchange on which it is traded.

Different people have different definitions of what a penny stock is, but most define it as a stock that is trading for less than one dollar.

Others consider a true penny stock to be a stock worth less than one dollar that’s trading on a major stock exchange. It all boils down to who you ask. It really does not matter that a stock is traded on a major exchange because the defining element of a penny stock is the price of the stock and not the exchange on which it is traded.
Penny stocks come from companies with a small amount of market capitalization. Market capitalization (known as market cap) is the price of the stock multiplied by the number of shares outstanding or issued. Market Capitalization is the stock market value of a company’s stock. Penny stocks sometimes go by different names. Day traders and investors use that term interchangeably with terms such as nano-cap, micro-cap and and small-cap stocks but, in reality, those stock classifications have specific market capitalization ranges and definitions as follows:

Here are some definitions we have found for stock classifications:

Penny Stock – Stock with a share price below $1
Nano cap Stock - Company with a market capitalization below $50 million.
Micro cap Stock - Company with a market capitalization of between $50 million to $300 million.
Small cap Stock - Company with a market capitalization of between $300 million to $2 billion.

You can invest in penny stocks with a small initial investment, but you usually have less information to go by when it comes to evaluating the company. With a larger company that has stocks trading at more than a dollar, you are typically able to access company filed SEC reports to research a company before you invest in it.

But even though penny stocks sometimes don’t afford you that luxury, penny stock investing can be a way to get in on the ground floor of investing with an up-and-coming company that has limitless potential. You may have to do more digging to do your homework on penny stock companies, but it can sometimes pay off handsomely in your investments.

If you find a penny stock that you’d like to consider, you want to check to see if the company has made their financial reports available to the public. Several resources to check include:

Pink Sheets (www.PinkSheets.com )
OTC Bulletin Board (www.otcbb.com )
EDGAR Filings Database (http://www.sec.gov/edgar/searchedgar/webusers.htm )

If you find anything unusual, such as the auditors haven’t certified a company’s financial statements, then you should be cautious about trading in that stock. Another red flag is if the auditors have declared that the company may not have enough money to keep operating.

Many Pink Sheets listed companies do not file with the SEC at all, but some file what is known as 15c211 filings which is typically a precursor to moving onto the OTCBB exchange. The basic idea behind designing Rule 15c211 was to provide fully reporting public companies an easy way to have their securities quoted on the National Association of Securities Dealers' Over-the-Counter Bulletin Board (NASD OTCBB). A company intending to obtain a quotation for its securities has only to file in some simple disclosures through form 15c211, commonly known as form 211, with NASD, and once approved, it will be able to trade its stock on the OTCBB.

With penny stock investing, there are minimal SEC requirements and standards these companies have to meet for their listings when they are Pink Sheets and OTCBB (OTC Bulletin Board) listed companies.

Where does risk play a factor in penny stock investing? While the cost to trade penny stocks is relatively low, the risk is a bit higher because you don’t have a way to see the history of the company or the stocks and how it factors into your investment strategy.

Why Penny Stocks?

Penny stocks can be thought of as the race horses of investing. They are fast and exciting, and like race horses, some can ride like the wind while others limp down the stretch or stop altogether.

Obviously nobody wants to be involved in the “limping down the stretch” thing, but there are certainly strategies that penny stock investors can employ to reduce the worst case scenerio. On the other side of the coin, realizing 100%, 200% or even 1000% gains in a short period of time is common with penny stocks.

The main reason most OTCBB investors keep trading these securities is the profit potential. Obviously, a huge Blue Chip stock can’t double in size in a short period of time. That doesn’t give investors too much to work with. On the flip side, a $2 million company can double in size overnight pretty easily. Which would you rather have in your portfolio?

The second reason is also a fairly straight forward one. Because many of these micro cap companies are working on a much smaller scale, the overall general market attitude has a very small effect on them. There are almost never any big institutional investors or large mutual fund managers pulling money in and out of these micro cap companies or penny stocks. These two groups of investors are more interested in macro market sentiments than what individual companies are doing. So, in bear markets, it’s quite possible to have a good number of these OTCBB companies take off like a rocket.

A 2001 study published in the Journal of Alternative Investments shows that over a four year period of time studying OTCBB stocks for a risk to return ratio they found that OTCBB stocks didn’t reflect what the general market was doing at that time. There were some years of extreme bullish overall sentiment and the overall OTCBB market lost a lot of money. On the flip side, years of extreme bearishness in the major markets, along with the major exchanges, showed positive returns for many OTCBB companies.

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The Risks of Investing In Penny Stocks

The first thing you as a new investor should be aware of is the high risk involved with small cap investing. When you buy a company like CSCO, IBM, MSFT, GE, or DELL, you are buying a quality company, backed by big names and run by hundreds of managers and consultants. Small cap companies are often run by only a handful of people. Often there is the CEO/founder/president, perhaps a COO and a few other employees.