If you are in the market looking to invest in stocks, then penny stock is a term that you may have come across. But what are they and how are they different than the other average stocks? And are they a great deal because they only cost a penny?
To begin, let’s clear out that penny stocks, unlike the name, unfortunately is never equivalent to pennies; according to the U.S. Securities and Exchange Commission (SEC), a penny stock “generally refers to a security issued by a very small company that trades at less than $5 per share” – about $3-$5 value is where you will find most penny stocks. A good rule of thumb is that any stock found trading on the pink sheets or over-the-counter bulletin board (OTCBB) should be considered a penny stock. So, with the price of stock being so low, is there a potential in making money by investing in them? Yes, you can, but only if you play smart; there have been several cases where penny stocks have grown more than 8 times their value in matter of days, but you have to become familiar with the risks associated to trading them.
For the sake of mentioning the obvious, never get involved with the penny stock offers that you will find in your spam email; spam penny stocks are a trend and one of many reasons why they have a poor reputation. Unfortunately, the penny stocks spams aren’t limited to just emails – there are proper advertisements, forum discussions/chat rooms, and even legitimate websites that can trick you into investing. So, the best way to start is by researching the company as thoroughly as possible before investing – not only should you know what the company is about, but also the people on the board and running the company, their policies, their history, etc.; because penny stocks are offered by companies that are not well known, finding information on them can be very tedious. Like mentioned before, you will find the listings for penny stocks in Pink Sheet and OTCBB (in fact, never invest in a penny stock if it is not mentioned in the OTCBB); very rarely would you ever find a penny stock listed in NASDAQ or NYSE. However, there are fairly cheap options seen NASDAQ and NYSE that are much safer than penny stocks, so you may want to take a look there first.
Like any investment, you want to be able to convert the assets into cash; this however is one of the risks when dealing with penny stocks. Because liquidity is low in the penny stock game, you can easily end up investing in stocks that yield no gain and even go bust (lose their entire value); so, invest in the ones that have shown a good history with liquidity. An easy way to look for this is to find how much money is going in and out in a day’s worth of time.
Because penny stocks don’t abide by the same strict guidelines as other stocks do, volatility becomes another risk for an investor; companies offering penny stocks can be very poor at submitting their data to OTCBB – well below compared to what the standard is for Wall Street. The problem is that the companies that do report poorly still show up and very easily appeal to untrained investors. Also, with the lack of proper guidelines/restrictions, often times the companies or scammers deliberately keep poor track of their financial records and manipulate the stocks to make them appealing.
One of the most common schemes in the stock market is the “pump and dump”. This is how it works: you see an advertisement for a new product or an idea that everyone is going to love. It starts getting mentioned all over the place; you see it in newsletters, chat rooms, bulletin boards, and other mediums and suddenly it has the reputation of being a “hot” stock. Many times, these signs are enough to convince people in buying the stocks, but what has really happened is that the company itself has bought a good chunk of stocks and by convincing you to join in, you have helped them raise the value of their stock as a whole. But, the second it accumulates enough value, they will cash out and stop all promotions. This leaves the value of the stock to significantly decline and more importantly leaves you, in losses. And because often times there is not enough financial information on small businesses that participate in this trade, finding out which ones are genuine can be extremely tricky.
So, now that you know all the risks, let’s recap the strategies that should be implemented to play the game smartly. First, as mentioned before, start by knowing all the details about the company; their policies, ethics, goals, operators, etc. Look for ones that have a good reputation! Second, learn how the company handles its financial responsibilities; it is important to learn how efficient they are at filling their reports and how healthy the business is financially. Lastly, read the footnotes; odd involvements and non-GAAP (generally accepted accounting principles) transactions are mentioned in the footnotes and can give you a clear idea regarding the companies’ authenticity. Investing is a gamble and with all risks can come negative consequences – so be vigilant and do your homework when it comes to penny stocks. And don’t expect to become a millionaire overnight.