What Are Penny Stocks?
If you've spent any time searching for investment advice online, you've almost certainly come across penny stocks...
A penny stock is any equity that trades below $5, according to the SEC's definition. Others consider it to be any stock trading below $1.
Regardless of which definition you prefer, one thing is clear: Penny stocks are cheaply traded, low-liquidity investments.
They generally trade on the over-the-counter bulletin board (OTCBB), pink sheets, or a securities exchange. This makes them highly accessible, and the low price can make them pretty tempting. But penny stocks are high risk for the same reasons that they are tempting.
Any stock that is priced so low could go up quickly and exponentially... but it could also drop just as much and just as fast.
That's not to say penny stocks are always a bad bet; if you're careful — and lucky — they can be pretty profitable.
But you should do your own due diligence and are aware of the risks before investing.
Because of their low price and over-the-counter exchange, penny stocks have less filings and regulatory standards than regular stocks.
Issuers listing on the OTCBB are required to maintain current filings with the SEC, and they even risk removal if they don't update the information. Other than that, regulations are pretty limited.
But stocks listed on the pink sheets do not have to file with the SEC at all.
Because of this, it's difficult to find information — or at least accurate information — on these stocks, so they're hard to research before a transaction.
The low price might trick some investors into thinking it's a newly-traded company bound to go up. But most IPOs list higher than $5...
For example, online travel company Kayak (NASDAQ: KYAK) opened at $26.00. Discount retailer Five Below, Inc. (NASDAQ: FIVE) debuted at $17.00.
Instead, penny stocks are often likely to be priced low because the company is on the verge of bankruptcy. When corporate revenue has plummeted, share prices will as well. And if the company does go bankrupt, shareholders could lose their investments.
It could also be a brand-new company. In this case, though it might not be on the verge of going under, it will have very little company history. Investors will have a hard time finding solid information on the company to qualify their investments.
And because the stock is priced so low, it has very low liquidity — meaning that when the time comes to sell, it might be difficult to do so.
The SEC has some regulations laid out specifically for high-risk stocks like these in order to protect investors...
Before a penny stock can be sold, the customer must receive documents making him or her aware of the risks of the stock. In turn, the customer must send back a written agreement to accept the risks. The company must then send monthly account statements and updates to the investor so that the he or she is aware of as much as possible.
Identifying the Pump-and-Dump
Prices might also often fluctuate because penny stocks can be easily manipulated.
They are the main targets of pump-and-dumps — when fraudsters hype up the stock by buying large amounts... and then selling as soon as people catch on and the price rises.
Offshore brokers or foreign investors have also been known to buy these stocks at a discount, selling them back into the U.S. for a profit.
The point of a pump-and-dump is profit for the fraudster, and in turn the targets suffer major losses. It's basically a Ponzi scheme for stocks, wherein the first in make the most.
It usually happens through email hype... A nameless stockpicker will flood your email inbox with announcements of a new play. Generally, there is some kind of red flag that makes you realize this isn't your ordinary financial analyst. They might give a future date on which they'll announce their next pick, but then give away the name of the stock in the same email... or they'll say they recommended it at a price that was long gone by the time you receive the recommendation.
The trouble is pump-and-dumpers are sometimes disguised as regular stockpickers. But a careful eye can differentiate the two...
The basics of it are this: Pumps generally last only as long as it takes for those who financed the pump to drop their shares on their less-than-informed readers.
Some are quick cut-and-run overnight-type deals with just a few emails blasted out into the ether of cyberspace a couple times before vanishing forever; others are longer, more intricately-orchestrated affairs that can cause literally hundreds of millions of dollars to change hands.
Usually, the best way to tell the difference is by looking at the source of the emails.
If you're reading updates and alerts from a nameless author, chances are it's a pump.
If the text of the update or alert contains as many exclamation points as hard facts about the company, chances are it's a pump.
Finally, if you're being promised 100s of percent gains if you just hold out through another day or two, hang tough through the short squeeze — or better yet, double down on the dip — chances are it's a pump.
That said, not all penny stocks are fraudulent and scary.
Yes, you do have to enter cautiously and make sure you do your research, but sometimes it's possible to make big gains off these plays...
You can find penny stock recommendations from decent sources. Of course, there are plenty of recommendations that play to the stock's big gains without a consideration of the risk — but then there are the solid recommendations from reliable sources.
Find a recommendation from a company or source that does more than just recommend and hype up penny stocks. Though there's no guarantee they'll be right, as any stock is a gamble, they're more likely to be steering you in a direction from which you can profit, instead of a direction from which only they will profit.
Again, watch out for pump-and-dumpers. Use the techniques listed above to determine if you're receiving a solid recommendation. And find out as much as you can about the company: Look for press releases, earnings reports, and upcoming announcements to decide if they're sticking around for a while and not on the verge of bankruptcy. History is key.
If it is a new company, do what you can to learn about upcoming projects or deals with larger companies that could make a splash.
And of course, none of this will offer 100% guaranteed success...
You're still taking a risk. And penny stocks are a bigger risk than regular stocks.
But if you think you can handle all the risks that come with penny stocks, and if you've done your due diligence, you might stand to make a healthy profit...
Big risk, big reward.
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