What Are Penny Stocks & Should You Buy? How to Analyze Them? Full Information

Penny Stocks & Should You Buy
What Are Penny Stocks & Should You Buy? How to Analyze Them? Full Information (Image Source: Unsplash)

What are penny stocks?

What are penny stocks?
What are penny stocks? (Image Source: Unsplash)

Penny stocks are those that often trade on a smaller exchange, have very tiny market capitalizations, are largely illiquid, and trade at extremely cheap prices. Due to their high risk, little liquidity, tiny shareholder base, wide bid-ask spreads, and restricted information availability, these stocks are exceedingly speculative in nature.

Knowledge about penny stocks

Penny stocks are securities or financial instruments that reflect a certain financial value, issued by tiny public corporations and traded at less than $5 per share, according to the U.S. Securities and Exchange Commission (SEC). Instead of on the trading floor, penny stocks are valued over the counter. Prior to the SEC’s categorization, shares that traded for “pennies on the dollar” are referred to as “penny stocks.”

The Securities Exchange Commission (SEC) at the time disclosed that equity securities with a market value of less than $5 per share could not be listed on any national stock exchange or index when the United States government passed the Securities Exchange Act in 1934 to regulate any and all transactions of securities between parties who are “not the original issuer.”

Penny stock over-the-counter exchanges include OTC Bulletin Board (a FINRA facility) and OTC Link LLC (which is owned by OTC Markets Group, Inc., formerly known as Pink OTC Markets Inc.). On stock markets, including international stock exchanges, penny stocks can also be traded. Securities from some private firms with no active trading market may be included in penny stocks.

Due to the low liquidity of the penny stock market, it can sometimes be challenging for investors to liquidate their investments. However, scholarly research demonstrates that the size and liquidity premium causes the risk brought on by small market cap size and lesser liquidity to result in greater projected returns.

The SEC and the Financial Industry Regulatory Authority (FINRA) have precise guidelines that define and control the selling of penny stocks in the United States.

Penny stock characteristics

Compared to other shares, the price of penny stocks might fluctuate significantly. That they will provide good returns on investment cannot be guaranteed. Without prior notice, penny stock values might decrease. Don’t put all of your investment eggs in one basket if you want to invest in penny stocks.

Trading penny stocks is not for everyone. Only invest what you can afford to lose because it is dangerous. There is no assurance that a specific penny stock will increase in value, even if your research suggests that it will.

Here are some characteristics of penny stocks:

Here are a few traits of penny stocks:

  1. Low cost
  2. Unpredictable results
  3. High-risk element
  4. Low trading activity
  5. Small market capitalization
  6. The nature of speculation
  7. Rapid price changes
  8. Smaller firm

How are penny stocks made?

How are penny stocks made?
How are penny stocks made? (Image Source: Unsplash)

In order to raise money to expand their businesses, small businesses and startups frequently issue stock. Even though it takes time, issuing stock is sometimes one of the easiest and most efficient methods for a small firm to raise money.

Similar to other publicly traded stocks, penny stocks are founded through a procedure known as an initial public offering, or IPO. Before the firm may be listed on the OTCBB, it must submit a registration statement to the SEC or document that the offering is exempt from registration. Additionally, it must research local securities regulations in the states where it intends to offer the shares. Following approval, the business may start the process of asking for investor orders.

Finally, the business has two options: it may request to list the shares on a bigger exchange or use the over-the-counter market.

Pros and Cons of penny stocks

Pros

  1. Provide a channel for small businesses to get public money.
  2. Penny stocks may occasionally offer a way to access more extensive market listings.
  3. Penny stocks provide a high upside in share gain due to their cheaper pricing.

Cons

  1. Even after their price has grown, there may not be many buyers for penny stocks, therefore they lack a liquid market.
  2. The company’s financial performance is only sparingly disclosed.
  3. Penny stocks have a significant likelihood of fraud and the underlying company’s insolvency.

Penny stock volatility

Penny stock volatility
Penny stock volatility (Image Source: Unsplash)

Penny stocks sometimes reflect developing businesses with little money and resources. Penny stocks are best suited for investors with a high tolerance for risk as they are typically small businesses.

Penny stocks often have higher levels of volatility, which leads to bigger potential rewards and, consequently, higher levels of inherent risk. On a penny stock, investors run the risk of losing their whole investment or even more if they buy on margin, which implies they borrowed money from a bank or broker to buy the shares.

Investors need to take into account the increased risks linked to penny stocks. For instance, an investor should know what price level to exit at in the event that the market swings against them and have a stop-loss order prepared before beginning a transaction. Stop-loss orders specify a price cap over which the shares will be automatically sold.

Although penny stocks offer the potential for huge returns, it’s important to keep your expectations in check and realize that they’re high-risk investments with little liquidity.

Can penny stocks make you money?

For a cautious or diligent investor, penny stocks may be beneficial despite the hazards. The goal is to steer clear of classic speculative investment misconceptions, such as the notion that there is a chance for significant returns. This is true, but they also have an equal chance of suffering significant losses.

The low-price fallacy, which asserts that low-priced securities are intrinsically “cheaper” than higher-priced ones, is another significant mistake to avoid. However, this does not take market capitalization or liquidity into consideration. Even if the price of a particular stock double, it could be hard to sell many shares without triggering price slippage.

How to buy the best penny stock?

Penny stocks may be riskier than ordinary stocks, but that doesn’t mean you should absolutely shun them. After all, you can profit a little from your investments. Having learned everything there is to know about particular penny stocks, let’s now discuss some of the things you should keep in mind.

Research is important for every investor. You are the best person to understand your position. Long-term success depends on you carrying out your due research. This implies that you should research the firm, the dangers associated with it and if it aligns with your personal investing plan.

Consider whether investing in the underlying company makes sense to you. Don’t invest in a company’s shares simply because someone else says to or because it could be the fad of the day.

Make sure you review whatever materials the business provides, particularly its financials. Are these credible claims? It may indicate a wise investment if the firm submits its financial statements on schedule and they demonstrate the company’s financial stability. Make careful to investigate the organization that will be auditing the firm as well.

Investors’ worries

When buying penny stocks, investors should be aware of some inherent risks, such as the often lack of knowledge surrounding the firms selling the stocks. A narrow market and a lack of public reporting are frequently the ideal conditions for stock promoters to manipulate the price of a stock. These people frequently buy significant amounts of stock and then work with promoters to artificially increase the share price of penny stocks using incorrect and misleading information. A “pump and dump” scam, a type of microcap stock fraud, is when a manipulator sells their shares when liquidity and price rise.

The Federal Bureau of Investigation (FBI) released a report on a story on April 3, 2017, that focused on penny stock fraud. The report claims that Zirk de Maison, a native of California, was convicted of running a “pump and dump” operation in which he and his friends persuaded sizable crowds of investors to buy shares in businesses he had set up as fronts.

The prevalence of the Internet and mobile phones has made it simpler to pull out penny stock frauds. Since the Securities & Exchange Commission permitted the use of social media platforms like Twitter to disclose public information instead of press services, many fraudsters have set up accounts to take advantage of the increased volume of traffic on social media, giving investors another factor to take into account when looking for reliable sources of information.

Relevant examples

By the 1970s, Wall Street had become a Mafia stronghold. 1980s penny stock manipulations were carried out by Lorenzo Formato. In Congressional hearings, Formato admitted that he was a part of organized crime throughout the time that he promoted and sold penny stocks and that organized crime routinely manipulated the prices of these stocks. The Penny Stock Reform Act of 1990 was approved following the congressional hearings.

In 1989, penny stock fraud schemes were defrauding American investors of at least $2 billion annually.

It has been stated that throughout the 1990s, gang involvement on Wall Street surged. The Mafia criminal organizations are increasingly turning to white collar crimes, according to a February 10, 1997 article in The New York Times, with an emphasis on “little Wall Street brokerage businesses.”

Tellier & Co. was one of the largest penny stock operators in the 1950s. The “Blind’em and Rob’em” brokerage firms Blinder Robinson, First Jersey Securities, Rooney Pace, and Stuart-James were all significant penny stock brokers in the 1980s. In the 1990s, Stratton Oakmont, Sterling Foster, A.S. Goldmen, and Hanover Sterling were significant penny stock brokerages.

Regulation on penny stock

A penny stock is a security that satisfies a number of precise criteria, according to American authorities. Price, market capitalization, and a minimum level of shareholder equity are among the factors. Since it is believed that exchange-traded securities are less susceptible to manipulation, all securities traded on a national stock exchange, regardless of price, are excluded from regulatory designation as penny stocks. Therefore, although being correctly characterized as “low-priced” assets during the market slump of 2008–2009, Citigroup (NYSE:C) and other NYSE-listed securities that traded below $1.00 were not strictly “penny stocks.”

Although SEC and FINRA rules and regulations are currently the main means of regulating penny stock trading in the US, State securities laws are where this control first emerged. The first state to adopt a thorough regulation of penny stock securities was Georgia. The measure was primarily supported by Secretary of State Max Cleland, whose office was responsible for upholding State securities rules. The primary sponsor of the measure in the House of Representatives was Representative Chesley V. Morton, who at the time was the only stockbroker serving in the Georgia General Assembly. Following that, Georgia’s penny stock statute was contested in court.

However, the bill was ultimately upheld by the U.S. District Court, and it served as the model for statutes passed by other states. Soon after, the SEC and FINRA both passed extensive amendments to their rules governing penny stocks.

Brokers/dealers that specialized in the penny stock market, like Blinder, Robinson & Company, were effectively shut down or severely restricted thanks to these restrictions. After his company failed in 1992, Meyer Blinder was sentenced to prison for securities fraud.

Buy fractional shares instead of penny stocks.

Buy fractional shares instead of penny stocks.
Buy fractional shares instead of penny stocks. (Image Source: Unsplash)

Learn about fractional shares if you want to invest in stocks but only have a tiny sum of money. With fractional shares, investing applications and online brokerages enable the purchase of substantial, recognized public firms for as little as $5, and occasionally even less.

For a nominal monthly membership charge, micro-investing applications like Acorns and Stash enable you to make quick stock market investments in exchange-traded funds and fractional shares (ETFs).

Avoid penny stocks. For the majority of people trying to increase their wealth, experts advise investing using these more tried-and-true strategies.

Ending lines

Penny stocks are dangerous because the majority of over-the-counter equities have little public information available. There’s really no reason to view penny stocks as a prudent investment when there are so many alternatives that enable individuals to start investing with $5 or less and yet enjoy reliable historical returns.

Some of the firms listed on the OTCBB and pink sheets may be of high calibre, and some OTCBB companies are putting in a lot of effort to move up to the more prestigious Nasdaq and NYSE. There are, however, profitable stock trading possibilities that don’t cost pennies. Although penny stocks are not hopeless, they are extremely risky investments and not all investors should choose them.

If you find yourself drawn to micro-caps, make sure you thoroughly investigate them and know what you’re getting into.

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