Playing Around with Penny Stocks

What are Penny Stocks?

Penny stocks are common shares of small public companies that possess low trading volumes and the assumption of greater risk. All securities classified as “penny stocks” will trade at less than $1.00 and are located outside of the major stock exchanges—penny stocks are not traded on the New York Stock Exchange, NASDAQ or any predominant stock exchange.

Penny stocks are primarily traded over-the-counter via the Pink Sheets or the OTCBBB quotation system. These exchanges compile all publicly-held companies that issue stock who are not located on the major exchanges. As a result of their location and low investment price, penny stocks are widely-regarded as highly speculative investments. The assumed risk in investment stems from the underlying company’s lack of liquidity, relatively enormous bid-ask spreads, limited following and small capitalization.

As a result of these characteristics, investments made into Penny Stocks should be attached with great caution. Although the limited investment represents an enormous return (the appeal of penny stocks is derived from their ability to “break out”) the small size and market space that these underlying companies possess represents a limited ability to accrue a worthwhile profit.

Penny Stock Concerns

The majority of stocks that trade for under $1 possess low trading volumes. Since such stocks are thinly traded, they are often targets for price manipulation. This illegal practice takes place, when a business entity or individual purchases hundreds of thousands or millions of shares, then uses faulty press releases, email blasts, and blogs to drive-up interest in the company.

This misleading or faulty information artificially drives-up demand, which in turn, pushes the price up. When the price rises (due to increased purchasing of the underlying stock) the original sellers will dump their lot of shares to secure an illegitimate profit. The expanding use of Internet forums and email blasts has made such scams easier to deliver.

Penny stock companies typically possess low liquidity, which makes it difficult for shareholders to sell their investments. In addition to such difficulty, low liquidity or limited holdings of cash represent a greater risk of default and an overall inability to satisfy loan payments.