Make Money 101: What is a Penny Stock?

In the United States of America, a penny stock, also known as a micro cap equity refers to a share in a company which trades for less than $5.00. While this is the official definition, and is used by the US Securities and Exchange Commission, generally every full service or discount broker, and the vast majority of analysts and institutional investors, there are informal (but paradoxically less inclusive) criteria applied by the general public and most retail investors. In other countries the term may be used differently, without reference to US institutions.

Some of these alternative criteria include

  • a price per share being less than $1, and as low as fractions of one cent;
  • a market cap of less than $50 million or less than $25 million;
  • Trading on more obscure markets, such as the Pink sheets.

While such definitions are sometimes used by individuals and retail investors, the various and loose unconventional definitions enjoy no consensus or accuracy.

As well, there are many limitations with the alternative definitions, as they often contradict themselves.

For example, there are many companies trading for only a few cents with market capitalizations of hundreds of millions of dollars, or corporations trading on the Pink Sheets but having share prices of $50 or more.

Both negative and positive connotations surround micro caps and low-priced shares.

Speculative investors are attracted to micro cap equities, because generally they

  • are more volatile;
  • make larger price moves in shorter time frames;
  • have greater upside potential on a percentage basis;
  • are easier to acquire with less initial investment.

More conservative traders usually shy from the smaller stocks, because

  • the underlying companies are often less secure or fundamentally sound (e.g., no earnings or negative earnings, negative book values);
  • many shares are too volatile, on both a price and percentage basis
  • the companies generally don’t pay dividends;
  • they aren’t subject to the same reporting requirements as Blue Chip equities, if they are on the lower level exchanges.

The two sides to the investment philosophy ring true to the old axiom, “high risk, high reward.”

Many newer investors are interested in micro cap equities because of the possibility of rapid and significant gains. However, there are several risk factors for traders that go beyond simple issues and concerns with the operations of the company.

For example, shares trading for less than $5 are considered by brokers to not be “option eligible”. Such securities are subject to higher trading commissions, much stricter levels for margin requirements, and usually cannot be used to borrow against. Generally, unless it is option eligible, the equity cannot be sold shorts.

In addition, depending on the liquidity of the underlying shares, and the exchange that the company is listed on, it can be problematic to sell your position. In extreme cases, investors may encounter difficulty liquidating their positions even when the shares are on the rise. This sort of problem is mainly prevalent on the Pink Sheets market, and less common among more legitimate exchanges such as the NasdaqOTC BULLETIN BOARD, or American Stock Exchange.

In addition, it is generally more difficult to find information of companies trading on the secondary markets. Often, a Pink Sheet company will be listed and traded, yet make no publicly accessible information regarding their financial position, the corporate fundamentals, or operational guidance.

Since many sub $5 companies are thinly traded, and especially those that trade for fractions of one cent, they are targets for price manipulation. For example, an individual or organization buys up hundreds of thousands, or even millions of shares, then uses web sites, faulty press releases, and e-mail blasts to drive interest to the company. Very often, faulty or misleading information is provided, resulting in investors buying shares in the underlying company. The increased demand pushes the price up, while the original individual or organization doing the “pumping” sells their holdings.

While such practices are illegal, and significantly less common in recent history, they are part of what has given the industry, and micro cap shares, such a bad name.

Another fraudulent scheme is the sale of chop stocks in which shares acquired below market under Regulations S are illegally sold to overseas or domestic retail investors.

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