Penny stocks can be used as a catch-all term for several types of speculative stock investments,
but most commonly, it refers to small public companies trading for less than $5 per share.
Penny stocks are typically not listed on U.S. stock exchanges like the NYSE or NASDAQ.
Instead, they're traded through a different method called over-the-counter, which is why
they're also called OTC stocks.
Note that not all OTC stocks are under $5 per share, but we'll discuss technical definitions
later.
Some traders are drawn to penny stocks because their low price means they can buy a lot of
shares and profit from small changes in the stock price.
However, high volatility and frequent fraud can make investing in penny stocks and similar
speculative securities very risky.
Understanding some key definitions as well as the unique risks that come with trading
these speculative securities can help you make more informed investing decisions.
When trading penny stocks and other speculative securities, it's important to understand
some technical terms.
Penny stocks is often used interchangeably with microcaps, OTC stocks, pink sheets, and
gray sheets, but the securities industry uses each term in distinct ways.
A microcap stock is generally considered any stock with a market cap of $50 million to
$300 million.
However, not all microcaps are penny stocks.
OTC, or over-the-counter, stocks include all stocks that are not traded on a U.S. stock
exchange.
Instead, they trade through dealer-to-dealer networks.
There are two systems that provide OTC stock price quotes to broker-dealers: OTC Bulletin
Board, or OTCBB, and the OTC Link, which used to be known as pink sheets.
Most penny stocks and microcaps do trade over the counter, but not all OTC stocks are small.
OTC stocks can be big or small, foreign or domestic, or can deal in products that are
considered illegitimate in some places, like marijuana stocks.
What OTC stocks have in common is not having the same reporting requirements as stocks
traded on major exchanges.
A final group of speculative stocks to be aware of is gray sheets.
These stocks haven't filed the necessary paperwork with FINRA to trade over-the-counter,
so they trade in the gray market with limited pricing information available.
What many of these types of stocks have in common is higher-than-average risk, which
stems from two main factors: lack of information and low liquidity.
Because they don't have the same reporting requirements as stocks traded on major exchanges,
many OTC companies offer little information for public analysis, and stock analysts rarely
cover them.
Without this data, it can be difficult to know which companies may have a weak business
track record or be on the brink of bankruptcy.
These risks are compounded by low liquidity, which may make it difficult for traders to
get orders filled near their desired price or filled at all.
With low liquidity, large orders can easily move the price.
In the case of stocks under $5, a move of a few cents can mean a major percentage gain
or loss, illustrating the tremendous volatility.
This lack of information and liquidity make penny stocks and similar speculative securities
particularly vulnerable to fraud.
For example, fraudsters have been known to use social media, direct email campaigns,
and discussion boards to promote a stock in an attempt to drive up the price.
Then, they profit by selling their own shares to unsuspecting traders, causing the stock
price to collapse.
This is in an illegal strategy known as pump and dump.
In 2018, one stock promoter was convicted for inflating the value of shares by approximately
$100 million.
With all of this risk and lack of information, you may wonder why anyone would trade penny
stocks.
Some investors are trying to get in on the ground floor of companies that may be ready
to break out and grow.
Others see low prices as a way to buy a lot of shares and profit from small changes in
the stock price.
For these reasons, trading in OTC stocks remains popular.
FINRA reported that from 2015 to 2018 the trade volume in all OTC stocks had increased
from more than $241 billion to $334 billion.
If you're willing to take on the risk for the potential return, make sure you have a
plan.
First, do your homework by studying the companies you're interested in.
Examine the company website and request a copy of the financial statements.
It's also important to be aware of the level of risk associated with different types of
companies.
For example, OTC Markets Group categorizes stocks by the amount of regulatory reporting
done, ranging from those that regularly provide financial data to the SEC or a U.S. bank to
those that provide none.
OTC Markets Group also monitors companies traded on its platform for fraudulent activity,
bankruptcy, regulatory filings, difficulty in contacting company executives, and so forth.
Investors interested in OTC stocks may find this to be an important resource.
And don't forget traditional risk management strategies like planning entries and exits,
using limit orders to help ensure you're getting a price you like, and investing relatively
small amounts to increase your chances of getting filled and limiting losses.
If you find yourself delving into penny stocks, microcaps, or OTC stocks, remember to weigh
the risk and return, do your research, and tread carefully.
An ill-informed foray into penny stocks could leave you penniless.
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