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| Penny Stocks |
In this article, I would like to explain basics and fundamentals behind the penny stock trading.
In community, some of the investors believe to find hidden gems means go through penny stocks in hope of finding the next Apple or Google but this is not the best strategy to trade penny stocks. Successful companies are not born but they are made.
What Exactly Is a Penny/Micro-Cap Stock?
Technically micro-cap stocks as the name suggests are classified based on their market caps while penny stocks are categorized based on their prices.
In general a stock with a market capitalization of $50 and $300 million is classified as Micro-cap ( Less than $50 million is a nano-cap) and stock under $5 is a penny stock according to SEC ( Securities and Exchange Commission ), but some considers $3 or less than $ 1 as a cut off price for penny stock. Stocks those are trading on the Pink Sheets or OTCBB are considered to be a penny stock.
First and main thing about penny stock is they are much riskier than regular stocks. For example junk bonds (bonds with a rating lower than BBB ) vs investment grade bonds ( bonds with a rating higher than BBB ). In terms of stocks it will be called penny stocks vs blue chip stocks.
What's the Problem with These Stocks?
What makes penny stocks risky? Four major issues arise when you decide to buy these securities:
1) Lack of Information Available to the Public
Investors are always rely on enough tangible information regarding key developments of the companies, and follow the news releases for informed and secured investments. This has less probability that their investments are at risk and wipe out over night.
For micro-cap stocks, information is much more difficult to find. Companies listed on the pink sheets are not required to file with the SEC and are thus not as publicly scrutinized or regulated as the stocks represented on the NYSE and the Nasdaq exchanges; furthermore, much of the information available about micro-cap stocks is typically not from a credible source.
2) No Minimum Standards
Stocks on the OTCBB and Pink Sheets do not have to fulfill minimum standard requirements to remain on the exchange. Sometimes, this is why the stock is on one of these exchanges. Once a company can no longer maintain its position on one of the major exchanges, the company moves one of these smaller exchanges. While the OTCBB does require companies to file timely documents with the SEC, the Pink Sheets has no such requirement. Minimum standards act as a safety cushion for some investors and as a benchmark for some companies.
3) Lack of History
Many of the companies considered to be micro-cap stocks are either newly formed or approaching bankruptcy. These companies will generally have a poor track record or none at all. As you can imagine, the lack of histories of companies only magnifies the difficulty in picking the right stock.
4) Liquidity
When stocks don't have much liquidity, two problems arise:
First, there is the possibility that the stock you purchased cannot be sold. If there is a low level of liquidity, it may be hard to find a buyer for a particular stock, and you may be required to lower your price until it is considered attractive by another buyer.
Second, low liquidity levels provide opportunities for some traders to manipulate stock prices, which is done in many different ways - the easiest is to buy large amounts of stock, hype it up and then sell it after other investors find it attractive (also known as pump and dump).
The Problem for Investors
Penny stocks have been a thorn in the side of the SEC for some time because micro-cap stocks' lack of available information and poor liquidity make these groups of stocks an easy target for fraudsters. There are many different ways these people will try to part you from your money, but here are two of the most common:
Biased Recommendations - Some micro-cap companies pay individuals to recommend the company stock in different media, i.e. newsletters, financial television and radio shows. You may receive spam e-mail trying to persuade you to purchase particular stock. All e-mails, postings and recommendations of that kind should be taken with a grain of salt. Look to see if the issuers of the recommendations are being paid for their services as this is a giveaway of a bad investment and make sure that any press releases aren't given falsely by people looking to influence the price of a stock.
Off-Shore Brokers- Under regulation S, the SEC permits companies selling stock outside the U.S. to foreign investors to be exempt from registering stock. These companies will typically sell the stock at a discount to offshore brokers who, in turn, sell them back to U.S. investors for a substantial profit. By cold calling a list of potential investors (investors with enough money to buy a particular stock) and providing attractive information, these dishonest brokers will use high-pressure "boiler room" sales tactics to persuade investors to purchase stock.
Buying These Stocks
Two common fallacies pertaining to penny stocks are that many of today's stocks were once penny stocks and that there is a positive correlation between the number of stocks a person owns and his or her returns.
Investors who have fallen into the trap of the first fallacy believe Wal-Mart, Microsoft and many other large companies were once penny stocks that have appreciated to high dollar values. Many investors make this mistake because they are looking at the "adjusted stock price", which takes into account all stock splits. By taking a look at both Microsoft and Wal-Mart, you can see that the respective prices on their first days of trading were $28 and $25 even though the prices adjusted for splits is $0.09722 and $0.02444 (at time of writing). Rather than starting at a low market price, these companies actually started pretty high, continually rising until they needed to be split.
The second reason that many investors may be attracted to penny stocks is the conception that there is more room for appreciation and more opportunity to own more stock. If a stock is at $0.10 and rises by $0.05, you will have made a 50% return. This together with the with the fact that a $1,000 investment can buy 10,000 shares convinces investors that micro cap stock are a rapid surefire way to increase profits. For some reason, people think of the upside but forget about the downside. A $0.10 stock can just as easily go down $0.05 and lose half its value. Most often, these stocks do not succeed, and there is a high probability that you will lose your entire investment.
Conclusion
Sure, some companies on the OTCBB and Pink Sheets might be good quality, and many OTCBB companies are working extremely hard to make their way up to the more reputable Nasdaq and NYSE. However, the flip-side is that there many good opportunities in stocks that aren't trading for pennies. You need to understand that this is a high risk area that isn't suitable for all investors. If you can't resist the lure of micro-caps, make sure you do extensive research and understand what you are getting into.
( Source: Investopedia )
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