Penny stocks, as the name suggests, are stocks that typically trade at very low market values in comparison to their original issue price. They may also be termed as micro cap stocks, but a technical difference is that micro cap stocks are determined on the basis of their low market capitalization, where as penny stocks are classified on the basis of their low market price.
The Securities & Exchange Commission (SEC) says that any stock that is below $5 in market price may be called a penny stock. Similarly, a stock with a market capitalization of less than $300 million is called a micro cap. The definitions of penny stocks are indicative, and investor perceptions may differ. Some experts like to set the cut-off limit for penny stocks at $3, while others specifically label penny stocks only if they are actually penny stocks: those trading below $1.
Penny stocks typically trade on Over the Counter Bulletin Board (OTC-BB). Stocks trading on the OTC and OTC-BB face very little regulation, which makes it pretty simple to purchase them. However, the trading activity is usually uneven in these stocks. These stocks are mostly issued by small companies that choose the equity route to fund their growth.
The risk-reward ratio in penny stocks is significantly higher in comparison to regular stocks. Therefore, while an investor may lose a lot of money with bad investments in these stocks, there is a fair chance to achieve exponential returns with smart investments in penny stocks. The key to success with penny stocks usually lies in choosing the right penny stock advisor, consultant, or broker that can provide astute investment advice.
How to Pick Penny Stocks?
One of the biggest challenges that an average investor faces when considering investments in penny stocks is to differentiate between the good and the bad stocks. The reputation of penny stocks suffers when some companies, brokers, or large investors attempt to manipulate the trading prices at the cost of small investors. In order to trade successfully in the penny stocks market, the investors should give due consideration to the following critical aspects.
Degree of Transparency
It is important to consider the amount of verifiable information available about a particular penny stock company and its business before making an investment. If the information is hard to come by, and the company is unwilling to share relevant sales performance, liquidity, and other financial data, caution should be exercised before placing faith in such a company. Pink Sheet companies are not required to file their figures with the SEC, which makes them less exposed to public scrutiny compared to regular stocks. Therefore, it is always a good idea to invest in penny stocks through a reliable and reputed penny stock consultant or broker.
Adherence to Minimum Standards
Penny stocks listed on OTC-BB are required to file documents on time with the SEC, but they still do not have any stringent minimum standard requirements to fulfil in order to remain on the exchange. The Pink Sheets do not even have the requirement to file timely documents with the SEC. Therefore, investors should consider penny stocks that adhere to the minimum standards as far as possible. That can be a fair benchmark to differentiate a promising penny stock from a dubious one.
Liquidity of the Stock
Penny stocks with a low level of liquidity are difficult to trade. Such stocks will typical remain in the low price zone because buyers are not willing to pay a higher price for them. The other problem that arises due to low liquidity and low trading volumes of a penny stock is that it gives an opportunity to some traders to manipulate the market prices by creating a hype and purchasing the stock to inflate its price artificially only to sell it off later (known as the “pump and dump” strategy).
Despite the obvious challenges of penny stock trading, average investors, with the support of genuine penny stock experts, and specialized penny stock brokers can multiply their investments many times over, if they act judiciously.