Penny stocks are low-priced shares of a relatively small company (think micro-cap & small-cap). The Securities and Exchange Commission considers shares trading under $5 a penny stock. However, most investors consider shares below $1 penny stocks. Shares of these companies (i.e., penny stocks) usually trade over-the-counter (OTC) in the U.S. and on the TSX-Venture / Canadian Securities Exchange (CSE) in Canada – not major exchanges like the NASDAQ, New York Stock Exchange or the Toronto Stock Exchange (TSX). As a result, the liquidity of many penny stocks is questionable; investors should take this into account prior to purchasing shares.
In the U.S., some of the notable listing services include the Over The Counter Bulletin Board (OTCBB), and the Pink Sheets. The former does hold listing requirements, similar to the major exchanges, while the latter does not. More than likely, investors can buy shares through their normal broker, unless limitations are in place (as is the case with brokers such as Robinhood).
As with all things, there’s a dark side to the world of penny stocks. Penny stocks are underfollowed in nature, which leads to a lack of transparency. This murkiness sets the landscape for all types of fraudulent activity such as stock manipulation. One of the most popular forms of stock manipulation in the penny stock space are “pump and dump” schemes – wherein shares of a company are promoted, in order to “pump” up the share price. As shares rise, the organizers of the scheme simultaneously sell – a.k.a. “dump” – their shares to oblivious buyers. Once the activity stops, investors are left holding the bag of a potentially worthless security.
On the other hand, the fact that penny stocks are underfollowed also provide tremendous opportunity. With all of the large Wall Street firms focusing their research efforts primarily on blue-chip companies, penny stocks tend to be overlooked – which can result in mispriced securities. Investors witty enough to take advantage of these mispriced securities can go on to make incredible returns which are unheard of in the blue-chip world. Although the potential loss when buying penny stocks is 100%, the upside can be many times higher.
At some point, many of the household names we’re all familiar with have traded as penny stocks – or at penny stock levels. Among these include Ford, where shares went as low as $1.80 during the great recession and now are many times higher in value.
Of course, the key to successful investing is performing thorough due diligence. This can’t be emphasized enough, especially in the volatile world of penny stocks. Regulatory agencies, such as the SEC, provide educational resources for penny stock investors, along with a variety of other information. Employing a disciplined approach to investing, and understanding the trade-off between risk and reward, should be key to anyone interested in buying penny stocks.
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