An Overview on Penny Stocks

Penny stocks are low-cost common stocks traded on over the counter markets (OTC). In general, a penny stock can be defined by (1) market cap, which normally is less than $50 million, or (2) price per share, which normally is less then $5. In any case, penny stocks do not trade on NYSE or AMEX. Some penny stocks trade on NASDAQ because of the companies that penny stocks represent are technology and biotechnology firms, which mainly trade on NASDAQ.

Penny stocks have no regulatory listing requirements as trading on over the counter markets (OTC) through quotation services like OTC Bulletin Board (OTCBB) or the Pink Sheets does not require filling financial statements with the SEC. For the penny stocks that trade on NASDAQ listing requirements are cheaper compared to NYSE, a factor that is vital for small companies. On the other hand, the lack of minimum accounting standards, change in notification of ownership of shares, and reporting of other material changes have a negative impact on the firm's financial viability and make penny stocks a highly risky investment.

Investors, who prefer investing in penny stocks, know that they undertake a high risk because penny stocks are highly volatile and have very limited liquidity. The fact that penny stocks represent small companies means that the number of shareholders, who share the risk incurred from daily trading, is small. This makes it difficult to sell and/or to short penny stocks because there may not be enough buyers. It also means that when investors realize a large buy or sell order of penny stocks, the price swings may be striking. It is not odd to see a drop of 20% or 40% during a trading and even return to their original starting point by the end of that same day.

The lack of financial reporting makes penny stocks vulnerable to manipulation, particularly those with low volumes traded over the counter. Because prices are low, manipulators may exercise naked shorting, which means to sell shares they actually do not own in the hope to buy them back when their price would be even lower. In the absence of a regulatory body to discourage manipulation these manipulative moves may greatly impact the market efficiency.

In fact, penny stocks are the extreme opposite of blue chips, which means that institutional investors are not interested to invest in penny stocks making these investments low-volume, cheap shares of unverified firms. On the other hand, the lack of institutional interest facilitates picking winning penny stocks. In blue chips, investors typically buy the stock and hold it until the price rises as a result of big market players buying massively the stock. In penny stocks, a rise in the price indicates that the firm gained interest from bigger players.