Common shares of public companies that trade at low prices are commonly referred to as penny stocks or penny shares, especially if the public company is fairly small. Penny stocks tend to be high risk investments due to a number of factors, such as low liquidity, small market capitalization, large big-ask spread, and limited following and disclosure. Even more importantly, penny stocks are highly susceptible to market manipulation.
There is no universally agreed definition of exactly what constitutes a penny stock, but in some parts of the world law makers or other regulatory bodies have set down their own definitions of the term. Further down on this page, you can find out more about how penny stocks are defined in the United States Exchange Act.
Investing in penny stocks
Investing in penny stocks is a high risk investment. Of course, investing in stocks is always risky, but penny stocks tend to be considerably more risky than other stocks. (In the opposite end of the spectrum, we find the so called blue chip stocks categorized by high prices and low volatility, typically being shares in well-established corporations.)
One of the reasons why investing in penny stocks is considered high-risk is the lack of minimum standards established and enforced by a stock exchange. Even though penny stocks can be traded at an exchange, over the counter (OTC) trading outside exchanges is much more common. Some legislative bodies have tried to provide at least a basic regulatory framework for stocks traded OTC, but it is a far cry from the rigorous requirements of stock exchanges such as the New York Stock Exchange, NASDAQ, London Stock Exchange Group, Japan Exchange Group, Euronext, etc. Sometimes the very reason why a stock is traded OTC instead of being listed at an exchange is because the company cannot live up to the requirements of any of the applicable exchanges.
Being traded OTC also means that the rules governing information dispersal are more lax or even non-existant. When a company is listed on an exchange such as NYSE or NASDAQ, it must adhere to very strict rules regarding not only what information that must be made available to the public but also when, how and in what format. Also, exchanges tend to have strict requirements about accounting practices.
With penny stocks, it can be tricky to find reliable information about the company. Also, when information is released to the public it may be done in a haphazard way which gives certain investors and advantage over others. Last but not least, you are less likely to be find any unbiased reviews and critical analysis about the company since penny stock companies are often too small to be of interest to major finance journalists and analyzers. Instead, a lot of the reviews you may encounter will be created (or paid for) by people who have an agenda that may not be to your benefit. They may for instance wish to pump up the value of these particular shares, or get you interested in penny stocks in general so they can sell you stocks through their platform.
Sometimes, the lack of information about a penny stock company is because there isn’t much information available to disperse in the first place. Penny stock companies are often newly formed companies, which means that there is a lack of history. Without any history, it becomes difficult to analyze the company and you may have to resort to unorthodox methods. You can for instance try to dig up information about important individuals in the company, such as CEO, board of directors, key R&D staff, etc and look at their respective history to find clues about how the company will perform.
Selling penny stocks
If you own stocks in a company such as Honda, Aviva or Coca Cola and wish to sell them, you can expect to find a buyer very quickly, and without having to drop the price far below yesterdays market price. This is because these stocks have a high liquidity – they are sold and bought in large numbers on every market day. They also tend to be pretty resilient to rapid changes in value unless something very special is happening.
With penny stocks on the other hand, it might prove difficult for you to find any buyer that is interested in purchasing your shares on a given day. Even if the company is still looking just as good or even better compared to the day when you purchased your shares, the low trading volumes might cause you to find no interested buyer or force you to drop the price really low to entice the interest of a prospective buyer.
When purchasing penny stocks, it is important to realize that it might take time for you to sell them – especially if you are unwilling to drop the price to entice bargain hunters. It is also important to remember that even small transactions can have a major impact on penny stock prices, so if someone else makes a sell you might need to stand back and wait quite a while before offering your penny shares if you want to get a good price for them.
Manipulating penny stocks
As mentioned above, penny stocks are highly susceptible to price manipulations. They are not very expensive to purchase, and the lack of reliable solid information also means that it is easier for incorrect or vague information to take the spot-light without being properly criticized.
Pump-and-dump is a scheme that can be carried out on many types of assets, but penny stocks are especially popular among pump-and-dump schemers.
How to carry out a penny stock pump-and-dump:
- Purchase a large amount of penny stocks in Company XYZ.
- Hype up Company XYZ directly, or hype up the product or service offered by Company XYZ with the aim of getting the share price to increase. Ideally, try to stay in the gray area of the law by using vague or personal statements rather then outright lies.
- When the share price of Company XYZ has risen, sell off all your stock in XYZ and make a nice profit.
- Once you stop hyping Company XYZ, the share price will probably drop significantly – especially when investors notice your large sell-off. But this is of no importance to you, because you no longer own any stock in Company XYZ.
I many jurisdictions, pump-and-dump schemes are illegal. However, convictions are rare since it is often difficult to prove who is behind a pump-and-dump scheme. Also, a skilled pump-and-dump schemer will stay in the gray areas of the law by making vague statements framed as personal opinions etc.
If you read a stock newsletter, you will normally find really find print information at the bottom of the newsletter where the sender admits to being paid to promote certain stock companies. This is a way of minimizing the risk of being convicted of pump-and-dump schemes or other similarly illegal activities concerning stock promotion.
Anonymous newsletters, blogs, twitter accounts and forum posts are frequently used to promote certain stocks and products. Sometimes starting a rumor on Facebook or posting an “informational” video on YouTube will be enough to temporarily increase the price of a penny stock. Sometimes you can even get the press to aid you in your efforts by sending them press releases about the company. Stressed out journalists wishing to meet their deadline are known to print well-written press releases without doing much research.
Penny stock definition in the United States Exchange Act
U.S. Securities and Exchange Commission (SEC) states that the term penny stock generally refers to a security that is
A.) Issued by a very small company, and
B.) Trades at less than $5 per share
SEC also highlights how penny stocks tend to be traded OTC rather than on exchanges (although SEC do mention that some penny stocks are traded on exchanges or have not active trading market at all).
For more information, go to Exchange Act Section 15(h) and Exchange Act Rules 3a51-1 and 15g-1 through 15g-100).