Penny Stock

What Is a Penny Stock?

A penny stock typically alludes to the stock of a small company that trades for under $5 per share. However some penny stocks trade on large exchanges, for example, the New York Stock Exchange (NYSE), most trade via over-the-counter (OTC) transactions through the electronic OTC Bulletin Board (OTCBB) or through the privately-possessed OTC Markets Group. There is no trading floor for OTC transactions. Quotations are also all done electronically.

Penny Stocks Explained

In the past, penny stocks were considered any stocks that traded for short of what one dollar for every share. The U.S. Securities and Exchange Commission (SEC) has modified the definition to include all shares trading below five dollars. The SEC is an independent federal government agency responsible for protecting investors as they maintain fair and orderly working of the securities markets.

Penny stocks are usually associated with small companies and trade rarely meaning they have a lack of liquidity or ready buyers in the marketplace. Accordingly, investors may find it challenging to sell stock since there may not be any buyers around then. Because of the low liquidity, investors could have difficulty finding a price that accurately mirrors the market.

Due to their lack of liquidity, wide bid-ask spreads or price statements, and small company sizes, penny stocks are generally considered highly speculative. In other words, investors could lose a sizable amount or all of their investment.

Price Fluctuations of Penny Stocks

Penny stocks offered on the marketplace are many times developing companies with limited cash and resources. Since these are primarily small companies, penny stocks are generally suitable for investors who have a high tolerance for risk.

Typically, penny stocks have a higher level of volatility, bringing about a higher potential for reward and, in this way, a higher level of inherent risk. Investors may lose their whole investment on a penny stock, or more than their investment in the event that they buy on margin, and that means the investor borrowed funds from a bank or broker to purchase the shares.

Considering the elevated risk levels associated with investing in penny stocks, investors ought to take particular precautions. For example, an investor ought to have a stop-loss order predetermined before entering a trade and understand what price level to exit on the off chance that the market moves inverse of the intended course. Stop-loss orders set a price limit that, once reached, will trigger an automatic sell of the securities.

Although penny stocks can have dangerous gains, it is important to have realistic expectations and understand that penny stocks are high-risk investments with low trading volumes.

What Makes Penny Stocks Risky

Penny stocks really do provide a workable small businesses with a way to access funding from the public. These companies may involve this platform as a starting block to move into a larger marketplace. Also, since they sell at such low prices, there is room for significant upside. Nonetheless, a few factors exacerbate the risk associated with investing or trading penny stocks. Securities are usually riskier than additional established companies known as blue-chip stocks.

A blue chip is a nationally recognized, deeply grounded, and financially sound company. Blue chips generally sell high-quality, widely accepted products and services. Blue-chip companies typically have a history of weathering slumps and operate profitably in the face of adverse economic conditions, which assists with adding to their long record of stable and reliable growth.

Lack of Information Available to the Public

While considering options for potential investments, it's important to have sufficient information to make an informed decision. For some penny stocks, information on corporate performance can be undeniably challenging to track down. At the point when this is the case, the information that is available about them may not come from believable sources.

Stocks traded on the OTCBB carry the "OB" postfix to their symbol. These companies file financial statements with the SEC. Nonetheless, companies listed on the pink sheets are not required to file with the SEC. As such these businesses don't receive the same public examination or regulation as the stocks addressed on the NYSE, the Nasdaq, and other markets.

No Minimum Standards

Stocks on the OTCBB and pink sheets don't have to satisfy least standard requirements to remain available to be purchased through OTC exchanges. When a company can never again maintain its listing position on one of the major exchanges, the company can move to one of the smaller OTC listing exchanges. Least standards can act as a safety cushion for certain investors. At the point when a company isn't subject to higher standards, investing in that company turns out to be a lot riskier.

Lack of History

Many of the companies considered to be penny stocks could be recently formed, and some could be approaching bankruptcy. These companies will generally have poor track records or no track record at all. As you can imagine, this lack of historical information makes it hard to determine a stock's potential.

Liquidity and Fraud

Stocks that trade rarely don't have much liquidity. Subsequently, it is conceivable that investors will not have the option to sell the stock whenever it is acquired. The investors could have to lower their price until it is considered attractive to another buyer.

Low liquidity levels also provide opportunities for certain traders to manipulate stock prices. The pump and dump scheme is a popular trading scam to bait investors into buying a stock. Large amounts of a penny stock are purchased followed by a period when the stock is advertised up or pumped up. When other investors race to buy the stock, the scammers sell their shares. When the market realizes there was no great explanation for the stock to rise, investors hurry to sell and can take on heavy losses.

However there is no idiot proof strategy for knowing which penny stocks are fraudulent, the SEC suggests that investors regard the following warning signs in a company's record: SEC trading suspensions, large assets yet small revenues, financial statements containing unusual things in the footnotes, odd auditing issues, and large insider ownership.

Real-World Example of Penny Stock Fraud

California resident Zirk de Maison created nearly half of twelve shell companies and offered them as penny stocks to investors somewhere in the range of 2008 and 2013, according to the Federal Bureau of Investigation (FBI). De Maison let investors know that the companies engaged in a variety of businesses, for example, gold mining and diamond trading when, in fact, they sat idle. He sold the stocks in "engine compartments," offices where brokers utilize high-pressure tactics to push individuals into buying stocks by promising large profits. In 2015, de Maison and seven other perpetrators were found at legitimate fault for securities fraud and condemned to federal jail.

How Is a Penny Stock Created?

Small companies and startups typically issue stock as a means of raising capital to develop the business. Although the cycle is extensive, giving stock is many times one of the fastest and best ways for a startup company to obtain capital.

A penny stock, similar to any other publicly traded stock, is created through a cycle called an initial public offering or IPO. To be listed on the OTCBB the company must initially file a registration statement with the SEC 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. When approved, the company may start the most common way of requesting orders from investors.

Finally, the company can apply to have the stock listed on a larger exchange, or it can trade on the over-the-counter market.

Underwriting Penny Stock

As with other new offerings, the initial step is hiring an underwriter, usually an attorney or investment bank specializing in securities offerings. The company's offering either should be registered with the SEC, according to Regulation An of the Securities Act of 1933, or file under Regulation D if exempt. On the off chance that the company is required to register, Form 1-A, the registration statement, must be filed with the SEC along with the company's financial statements and proposed sales materials.

The financial statements need to remain available for the public to survey, and ideal reports must be filed with the SEC to maintain the public offering. When approved by the SEC, orders for shares may be requested from the public by accompanying sales materials and disclosures, for example, a prospectus.

Trading Penny Stocks

After initial orders are collected and the stock is sold to investors, a registered offering can start trading in the secondary market by listing on an exchange like the NYSE, Nasdaq, or trade over-the-counter. Many penny stocks end up trading via OTC due to the severe requirements for listing on the larger exchanges.

Now and again companies make an additional secondary market offering after the IPO, which weakens the existing shares yet gives the company access to additional investors and increased capital. Furthermore, it is mandatory that the companies proceed to publicly provide updated financial statements to keep investors informed and maintain the ability for citing on the Over-the-Counter Bulletin Board.

The SEC's Rules for Penny Stocks

Penny stocks are considered highly speculative investments. To safeguard investors, the SEC and Financial Industry Regulatory Authority (FINRA) have rules to regulate the trading of penny stocks. All broker-dealers must agree with Section 15(h) of the Securities Exchange Act of 1934 and the accompanying rules to be eligible to handle penny stock transactions.

• Following Exchange Act rules of \u00a7240.15g-9, the broker-dealer must approve the investor's transaction and make sure the investment is suitable for their purchase.
• They must provide the customer with a standardized disclosure document as illustrated in \u00a7240.15g-2. This document explains the risks associated with buying penny stocks, customer rights, and arrangements in cases of fraud.
• Rule \u00a7240.15g-3 requires broker-dealers to reveal and confirm as of now quoted prices before finishing a penny stock transaction.
• Rule \u00a7240.15g-4 states the broker must inform the investor regarding the funds the broker earns from facilitating the transaction.
• Brokers must send month to month account statements that include details of the number and identity of each penny stock in the customer's account, as described by rule \u00a7240.15g-6. These statements must explain that the penny stock has limited market liquidity and provide an estimate of what they think the shares are worth in this limited market.

After-Hours Trading

Penny stocks can be traded after-hours, and since many significant market developments can happen after exchanges close, penny stocks are subject to volatile fluctuations after-hours. In the event that penny stock investors execute buy or sell trades after-hours, they may able to sell shares at extremely high costs or purchase shares at exceptionally low costs.

Nonetheless, even the best penny stocks are subject to low liquidity and inferior reporting. Also, in the event that a penny stock really does spike after-hours, an investor hoping to sell the stock could have a hard time finding a buyer. Penny stocks rarely trade, even more so after market hours, which can make it challenging to buy and sell after-hours.

When Is It Not a Penny Stock?

Numerous events 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.

The two types of transactions automatically require the firm to adhere to periodic reporting, including disclosures to investors about its business activities, financial conditions, and company management except if there is an exemption. These filings also mandate 10-Q quarterly reports, the annual Form 10-K, and periodic Form 8-K reports, which detail surprising and significant events.

In certain instances, there are additional conditions that will require a company to file reports with the SEC. Reports must be filed in the event that a company has either at least 2,000 investors, beyond what 500 investors that can't be categorized as accredited investors, and has more than US$10 million in assets.

Usually, companies without any than $10 million in assets and less than 2,000 recorded shareholders don't have to adhere to reporting guidelines under the SEC. Curiously, a few companies opt for transparency by filing the same types of reports that other, perhaps more reputable, firms are required to do.

Example of a Penny Stock

Most penny stocks don't trade on the major market exchanges. Nonetheless, there are a few large companies, based on market capitalization, that trade below $5 per share on the main exchanges like the Nasdaq.

One example of a penny stock listed on the Nasdaq is Catalyst Pharmaceuticals Inc. (CPRX), a small biopharmaceutical company based in Coral Gables, Florida. As of Jan. 7, 2021, the stock price is $3.55 per share. In the last 12 months, the share price has fluctuated somewhere in the range of $2 and $5. On August 10, 2020, the stock closed at $4.26; notwithstanding, the next day the price tumbled to $3.34 a drop of nearly 22%.

Although there can be sizable gains in trading penny stocks, there are also equal or larger risks of losing a significant amount of an investment in a short period.

Highlights

• Although some penny stocks trade on large exchanges, for example, the NYSE, most penny stocks trade over the counter through the OTC Bulletin Board (OTCBB).
• While there can be sizable gains in trading penny stocks, there are also equal risks of losing a significant amount of an investment in a short period.
• A penny stock alludes to a small company's stock that typically trades for under $5 per share.