A penny stock, also known as a micro-cap stock, according to the U.S. Securities and Exchange Commission is a stock with a share price below $5. However, many investors believe a penny stock sells for less than $1.
Investing in penny stocks is extremely risky because the share price can be extremely erratic. A very small change in price is large percentage-wise. For example, if you purchase a penny stock for $1.00 and it drops only 25 cents to $0.75, that stock has lost 25% of its value which is significant.
Penny stocks are mostly from very small companies and are traded on the Over-The-Counter-Bulletin-Board (OTCBB) and the Pink Sheets. These exchanges do not have the same minimum requirements as the large exchanges such as NASDAQ or the NYSE that are set by the Securities and Exchange Commission.
The following are disadvantages with investing in penny stocks:
Poor Investments
Penny stocks are poor investments because some companies will issue penny stock because they are close to bankruptcy or they are new companies with no proven track record.
Company Information is Limited
Companies listed on the OTCBB or Pink Sheets are not required to release financial information. Many companies also have little to no history for you to review or are brand names that you hear or read about in the media.
Low Liquidity
If you own a penny stock, you may have a hard time selling it when you are ready. If the stock price starts to fall, it may be difficult to sell it immediately as you would with a large-cap stock. There simply isn’t enough demand for most penny stocks.
Fraud
Because penny stocks are unregulated, they are commonly used by con artists to rip off people. They usually try and sell them via newsletters, spam emails, or off-shore brokerages that do not have to adhere to U.S. laws.
So why do people invest in penny stocks? Well, not all penny stocks are frauds or from companies nearing bankruptcy. There are some legitimate companies who struggle to meet the requirements to get listed on the NYSE or NASDAQ.
Investing in these companies may offer a huge growth opportunity should they become successful in the future. However, finding and researching these companies is extremely difficult because there isn’t enough information available.
Some people frequently trade penny stocks, known as day traders, which are basically gamblers. They will sit at their computers and watch for movements in various stocks and will try to quickly buy and sell at a higher price to make a profit. This is just like going to Las Vegas and gambling.