8 Jul 2018

What is a ‘Penny Stock’

A penny stock typically trades outside of the major market exchanges at a relatively low price and has a small market capitalization. These stocks are generally considered highly speculative and high risk because of their lack of liquidity, large bid-ask spreads, small capitalization and limited following and disclosure. They often trade over-the-counter through the OTC Bulletin Board (OTCBB) and pink sheets.


The term penny stock has evolved with the market. In the past, penny stocks were stocks that traded for less than a dollar per share. The SEC, however, has modified the definition to include all shares trading below $5.

Most penny stocks don’t trade on the major market exchanges. However, there are some large companies, based on market capitalization, that trade below $5 per share on the main exchanges like the Nasdaq. An example of a penny stock listed on the Nasdaq is Curis Inc. (CRIS), a small biotechnology company. That said, the typical penny stock is a small company with highly illiquid and speculative shares. The company is generally subject to limited listing requirements along with fewer filing and regulatory standards.

Things to Remember About Penny Stocks

Penny stocks are more suitable for investors with a high tolerance for risk. Typically, penny stocks have a higher level of volatility, resulting in a higher potential reward and a higher level of risk. Considering the heightened risk levels associated with investing in penny stocks, investors should take particular precautions. For example, an investor should have a stop-loss order predetermined before entering the trade, knowing where to exit if the market moves opposite of the intended direction. Investors may lose their entire investment on a penny stock, or more than their investment if they buy on margin.

Although penny stocks can have explosive moves, it is important to have realistic expectations. Typically, gains in the stock market take months and years to materialize. An investor who buys penny stocks with the intention of turning $100 into $50,000 over a week is likely to be deeply disappointed.

Penny stocks are often growing companies with limited cash and resources. In other words, most penny stocks are high-risk investments with low trading volumes.

To protect yourself, trade penny stocks that are listed on the American Stock Exchange (AMEX) or Nasdaq, as these exchanges are rigorously regulated. Avoid trading penny stocks that are not listed on a major exchange, such as a stock quoted on the pink sheet system in the over-the-counter (OTC) market.

What Makes Penny Stocks So Risky?

Four major factors make these securities riskier than blue chip stocks.

1. Lack of Information Available to the Public

The key to any successful investment strategy is acquiring enough tangible information to make informed decisions. For micro-cap stocks, information is much more difficult to find. Companies listed on the pink sheets are not required to file with the Securities and Exchange Commission (SEC) and are thus not as publicly scrutinized or regulated as the stocks represented on the New York Stock Exchange and the Nasdaq. Furthermore, much of the information available about micro-cap stocks is not from credible sources.

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 to one of these smaller exchanges. While the OTCBB does require companies to file timely documents with the SEC, the pink sheets have 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 poor track records or none at all. As you can imagine, this lack of historical information makes it difficult to determine a stock’s potential.

4. Liquidity

When stocks don’t have much liquidity, two problems arise: first, there is the possibility that you won’t be able to sell the stock. 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 to 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).

Signs of Fraud

Though there is no fool-proof safeguard with penny stocks, the SEC recommends that investors look out for the following warning signs: SEC trading suspensions, spam, large assets but small revenues, financial statements containing unusual items in the footnotes, odd auditing issues and large insider ownership.

Example of Fraud

In April 2017, California resident Zirk de Maison created half of a dozen shell companies and offered them as penny stocks to investors from 2008 to 2013, according to the FBI. Maison told investors that the companies engaged in a variety of businesses, such as gold mining and diamond trading when, in fact, they did nothing. He sold the stocks through “boiler rooms,” offices where brokers use high-pressure tactics to push people into buying stocks by promising large profits, embezzling $39 million. In 2015, Maison pled guilty to charges of securities fraud and he and seven other perpetrators were sentenced to federal prison.

How Is a Penny Stock Created?

A penny stock, like any other publicly traded stock, is created through a process called an initial public offering, or IPO. First, a company must file a registration statement with the Securities and Exchange Commission or file stating the offering qualifies for an exemption from registration. It must also check state securities laws in the locations it plans to sell the stock. Then, upon approval, the company may begin the process of soliciting orders from investors. Finally, the company can apply to have the stock listed on an exchange, or it can trade on the over-the-counter market, or OTC.

Small companies and start-ups typically issue stock as a means of raising capital to grow the business. Though the process is lengthy, involves mountains of paperwork and can be quite costly, issuing stock is often one of the most efficient ways for a start-up company to obtain necessary capital. Penny stocks are often the result of such ventures and can make for profitable but precarious plays for investors.

As with other new offerings, the first step is hiring an underwriter, usually an attorney or investment bank specializing in securities offerings. The company’s offering either needs to be registered with the SEC according to Regulation A of the Securities Act of 1933 or file under Regulation D if exempt. If the company is required to register, Form 1-A, which is the registration statement, must be filed with the SEC and is accompanied by the company’s financial statements and proposed sales materials. These financial statements need to remain available to the public for review, and timely reports must be filed with the SEC to maintain the public offering. Once approved by the SEC, orders for shares may be solicited from the public by accompanying sales materials and disclosures, such as a prospectus.

After initial orders are collected and stock is sold to investors, a registered offering can begin trading in the secondary market via listing on an exchange like NYSE or Nasdaq or trade over-the-counter. Many penny stocks end up trading in OTC markets due to the strict requirements for listing on the bigger exchanges. The majority of penny stocks do not meet such requirements, and the companies cannot typically afford the hefty cost and regulations involved. Sometimes companies make an additional secondary market offering after the IPO. This dilutes the existing shares but gives the company access to more investors and increased capital. It is important that companies issuing penny stock keep this in mind and work to gain value in the shares as they trade in the open market. Furthermore, it is mandatory that the companies continue to publicly provide updated financial statements to keep investors informed and maintain the ability for quoting on the over-the-counter bulletin board, or OTCBB.

The SEC’s Rules for Penny Stocks

Penny stocks are considered highly speculative investments. In order to protect the investor’s interest, the SEC and the Financial Industry Regulatory Authority (FINRA) have specific rules to regulate the sale of penny stocks. All broker-dealers need to comply with the requirements of Section 15(h) of the Securities Exchange Act of 1934 and the accompanying rules to be eligible to effect any transactions in penny stocks.

(1) Sales Practice Requirements §240.15g-9

Before effecting any transaction, a broker-dealer must approve the investor’s transaction (of specific penny stocks); meanwhile, the customer must give a written agreement to the broker-dealer for the same transaction. This measure has been taken to prevent manipulative, fraudulent practices in such investments. “Approving” the customer basically means checking his suitability for such investments. Approval should be given only after the broker-dealer has assessed the customer’s investment experience and objectives along with his or her financial position.

(2) Disclosure Document §240.15g-2

A broker-dealer must provide a standardized disclosure document to the customer. The documents explain the risk factor associated with investing in penny stocks, concepts related to the penny-stock market, customer rights, broker-dealers’ duties towards the customers, remedies in case of fraud and other important information which can be handy for an investor. The investor would be well-advised to go through this document so as to take informed decisions.

(3) Bid-Offer Quotations Disclosure §240.15g-3

It is mandatory for a broker-dealer to disclose and later confirm the current quotation prices and related information to the customer before effecting a transaction. If a broker-dealer doesn’t follow the same, it is considered unlawful. This helps the investor to keep a track of the price movement in the marketplace.

(4) Compensation Disclosure §240.15g-4

This rule makes the investor aware of the money being earned by the broker-dealer from a certain transaction. This can help the customer to judge if the broker-dealer has a selfish motive in trying to push a certain transaction.

(5) Monthly Accounts Statements §240.15g-6

A broker-dealer must send to its clients a monthly account statement which discloses details such as: the number and identity of each penny stock in the customer’s account; the dates of transaction; purchase price; and the estimated market value of the security (based on recent bids and purchase prices). Such statements must also explain the limited market for the securities and the nature of an estimated price in such a limited market. In cases where there have been no transactions effected in the customer’s account for a period of six months, the broker-dealer shall not be required to provide monthly statements. However, broker-dealers should send written statements on a quarterly basis.

After-Hours Trading With Penny Stocks

Penny stocks can be traded after hours. In fact, many of the largest market movements, both on the national public exchanges and on penny stock exchanges, happen after hours. Penny stocks are traded on listing services such as OTCBB and Pink Sheets. For after-hours trading of penny stocks, an investor would purchase those shares through a normal brokerage service, much like investing in traditional public securities.

Since a lot of market movements happen after exchanges close, penny stocks are subject to volatile fluctuations after hours. If penny stock investors execute buy or sell trades after hours, they may able to sell shares for very high prices or purchase shares for very low prices.

For example, these fluctuations have resulted in penny stocks jumping from 8 cents to $8 in a very short time frame, with these price spikes often happening after hours. After-hours trading allows investors to take advantage of these spikes, with a recent penny stock gaining almost 2,000% in a one-month period.

However, even the best penny stocks are subject to low liquidity and inferior reporting. Even if a penny stock does spike after hours, and if an investor would like to sell, it may be very hard to find a buyer. Penny stocks trade infrequently, even more so after market hours, making it very hard to buy or sell penny stocks after exchanges have closed.

This, coupled with poor reporting, makes it hard for investors to find up-to-date quotations on penny stocks, causing inaccurate pricing that gives penny stock investors pause and causes the purchase process to move even more slowly, especially after hours.

When Is a Penny Stock Not a Penny Stock Anymore?

There are multiple events that can trigger the transition of a penny stock to a regular stock. The company can issue new securities in an offering that is registered with the SEC, or it can register an existing class of securities with the regulatory body. Both types of transactions automatically require the firm to adhere to periodic reporting, including disclosures to investors about its business activities, financial condition, and company management unless there is an exemption. These filings also mandate 10-Q quarterly reports and annual Form 10-K and Form 8-K reports, which detail unexpected and significant events.

In some instances, there are additional conditions that will require a company to file reports with the SEC. Reports must be filed if a company has either at least 2000 investors or more than 500 investors that can’t be categorized as accredited investors, and possesses more than $10 million in assets. If a business lists its securities on any national security exchange, like the NYSE or the NASDAQ, it must file as well. Lastly, SEC registration is mandatory if a company’s securities are quoted on the OTCBB or under the OTCQB marketplace of the OTC Link.

Usually, companies with no more $10 million in assets and fewer than 2000 recorded shareholders don’t have to adhere to reporting guidelines under the SEC. Interestingly enough, some companies opt for transparency by filing the same types of reports that other, perhaps more reputable, firms are required to do.

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