What Is a Penny Stock Also Known As Microcap Stocks
What Is a Penny Stock Also Known As Microcap Stocks explained. The term penny stock or microcap stock typically refers to the stock of a small company that trades for less than $5 per share.
Though some penny stocks trade on large exchanges such as the New York Stock Exchange (NYSE), most trade via over the counter (OTC) transactions through the electronic OTC Bulletin Board (OTCBB) or through the privately-owned OTC Markets Group.
There is no trading floor for OTC transactions. Quotations are all done electronically.
Penny Stocks Explained
In the past, penny stocks were considered any stocks that traded for less than one dollar per share.
The U.S. Securities and Exchange Commission (SEC) has modified the definition to include all shares trading below five dollars.
The SEC is an independent federal government agency responsible for protecting investors as they maintain fair and orderly functioning of the securities markets.
Penny stocks are usually associated with small companies and trade infrequently meaning they have a lack of liquidity or ready buyers in the marketplace. As a result, investors may find it difficult to sell stock since there may not be any buyers at that time.
Because of the low liquidity, investors might have difficulty finding a price that accurately reflects the market.
Due to their lack of liquidity, wide bid-ask spreads or price quotes, and small company sizes, penny stocks are generally considered highly speculative. In other words, investors could lose a sizable amount or all of their investment.
While there can be sizable gains in trading penny stocks, there are also equal risks of losing a significant amount of an investment in a short period.
Price Fluctuations of Penny Stocks
Penny stocks offered on the marketplace are often growing companies with limited cash and resources.
Typically, penny stocks have a higher level of volatility, resulting in a higher potential for reward and, thus, a higher level of inherent risk.
Considering the heightened risk levels associated with investing in penny stocks, investors should take particular precautions.
A suggestion commonly made when dealing in penny stocks is having a stop-loss order Stop-Loss orders are instructions, placed with the broker, that set a price limit that once reached, will trigger an automatic sell of the securities.
However a stop loss order does not guarantee that there is a purchaser at the price that you set as your stop order and the stock might just fall to zero for lack of purchasers.
Penny Stock Vulnerability
Penny stocks due to their lack of national branding and recognition have shown to have a lot less staying power then what is called the blue chip companies such as Coke Cola, IBM etc. this is if all is even and you have access to all the information of blue chip and the penny stocks information.
What Makes Penny Stocks Penny Stocks
When you purchase an investment from a large Exchange Such as the NYSE there has already been some form of vetting as we previously explained there is a prestigious that goes along with being listed and passing the the vetting process.(unless it is a foreign company.) All the companies information is available to the public.
Penny stocks information can be difficult to obtain and even what you do obtain is not vetted or always credible. That said there are two distinct types of penny stocks one being transparent then the the other.
Stocks traded on the OTCBB carry the “OB” suffix to their symbol. These companies file financial statements with the SEC. Giving you some level of confidence and information.
Companies listed on the pink sheets, these companies are not required to file with the SEC. and therefore credible information and at least some transparency is almost nowhere.
Stocks on the OTCBB and pink sheets do not have to fulfill minimum standard requirements to remain available for sale through OTC exchanges.
Once a company can no longer maintain its listing position on one of the major exchanges, the company can move to one of the smaller OTC listing exchanges.
Minimum standards act as a safety cushion for some investors and as a benchmark for some companies.
Lack of History
Many of the companies considered to be penny stocks could be newly formed, or approaching bankruptcy and previously been listed on an exchange and then been delisted.
Liquidity and Fraud
Penny stocks don’t trade often making it hard to sell when you wan’t to. Or you will have to sell below what you believe the price value is.
The risk of a pump and dump scheme. This means that someone purchases a large number of shares and then creates tremendous excitement around the company leading to a rush and a quick rise in the price and then at a momment this individual sells off creating a tremendous profit for him and crashing the price of the stock.
Signs of Fraud In The Stock
Though there is no fool-proof safeguard with penny stocks, the SEC recommends that investors heed the following warning signs: SEC trading suspensions, spam, large assets but small revenues, financial statements containing unusual items in the footnotes, odd auditing issues, and large insider ownership.
The SEC’s Rules for Penny Stocks
Penny stocks are considered highly speculative investments. To protect the investors, the SEC and Financial Industry Regulatory Authority (FINRA) have rules to regulate the trading of penny stocks. All broker-dealers must comply with Section 15(h) of the Securities Exchange Act of 1934 and the accompanying rules to be eligible to handle penny stock transactions.
- Following Exchange Act rules of §240.15g-9, the broker-dealer must approve the investor’s transaction and make sure the investment is suitable for their purchase.4
- They must provide the customer a standardized disclosure document as outlined in §240.15g-2. This document explains the risks associated with buying penny stocks, customer rights and remedies in cases of fraud.
- Rule §240.15g-3 requires broker-dealers to disclose and confirm currently quoted prices before completing a penny stock transaction.
- Rule §240.15g-4 states the broker must tell the investor about the funds the broker earns by facilitating the transaction.
- Brokers must send monthly account statements that includes details of the number and identity of each penny stock in the customer’s account as described by rule §240.15g-6. These statements must explain that the penny stock has limited market liquidity and provide an estimate of what they think the shares are worth in this limited market.
Penny stocks can be traded after hours, this can lead to tremendous difference’s in the price of the stock and a lot of suprises.
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