Penny Stocks

 

 

 

 

 

 

 

A brief description of the general properties of Penny Stocks, its risks and the laws regarding Penny Stock sales by brokers.

 

According to the SEC Penny stocks are conventionally referred to as stocks that are priced at $5 or less, are not listed and do not trade on NASDAQ,

Laws Regarding Penny Stocks and the Rights of Investors

and do not have net tangible assets that exceed $2million if in operation for at least three years, do not have net tangible assets exceeding $5 million if in continuous operation for less than three years or do not have an average revenue of $6 million for the last three years.

They are generally described as being highly speculative. This is because they are issued by small, speculative start up companies which have a “growth story” behind them. In the US Penny stocks are usually traded at over the counter exchanges such the OTC Bulleting Board and the Pink Sheets.

More often than not they are traded on the OTC exchanges for the simple reason that the listing requirements are very lax. They only have to register with the SEC once and at the same time do not need to disclose financials and other important material which NASDAQ and the New York Stock Exchange require. Other names for Penny Stocks include micro-cap stocks and penny shares (England).

Penny stocks incorporate within themselves many risks including but not limited to: lack of liquidity, high volatility, lack of financial information, risk of bankruptcy and corporate scandals.

Liquidity

Manipulation by Management, Chat Boards and Email Spam.

Penny stocks are usually stocks with small market caps. This usually will result in a low quantity of shares traded per day which means that anyone wanting to trade a penny stock will have to either buy a small quantity or simply buy large quantities and affect its price. The reason for this is the following. A penny share will have a low market cap, which in turn will lead in the stock trading at a lower volume. A person who wants to hit a bid or ask will have to continuously hit it if the quantity he wants to buy or sell is large in proportion to the quantity being bid or asked. The monitors will show the bids and asks being cleaned off and whoever is on the other side of the market will adjust the price offered or asked to take advantage of the situation.

Lack of Financials

OTCBB and Pink Sheets do not require rigid listing requirements such as quarterly reporting. This results in a lack of transparency in the stock. A stock could have terrible financials or perhaps trade at a high price to book or price earnings ratio without the investor actually realizing it. Furthermore the fact that investors don’t have access to the annual report disables them from having the ability to check a lot of the legal and other qualitative factors which base many prudent investor’s decision to buy or sell a stock.

Volatility

Penny stocks are generally highly volatile for the following reasons. Their low price means that every unit change in price will be a big percentage change. For example if a 90 cent stock will have an 11% difference if it were to go down to 80 cents (10 cent difference). A hundred dollar stock would only have a 1% difference even if it were to drop a whole dollar.

The lack of liquidity mentioned above will mean that if someone wants to trade a reasonable volume would have to trade a significant amount of the day’s volume which will distort the price.

Furthermore given the speculative nature of these stocks and the lack of objective information means that these stocks will undergo heavier gyration if any events unfold which can affect its price. A simple legal case against the company can suspect bankruptcy whereas these effects can have a more marginal impact to large cap companies.