Day Trading 101: What is a Penny Stock?

what-is-a-penny-stock-dux

Day Trading 101: What is a Penny Stock?

Day Trading 101: What is a Penny Stock? 1024 493 Steven Dux

If you’re in the stock business and want to get a share for a low low price? You need to look into Penny Stocks. Penny Stocks are stocks that trade for $5  or less or under $5. Some Penny Stocks trade on the larger exchanges like the New York Stock Exchange (NYSE), but most are traded through an OTC, over the counter transaction and can also be traded on the Nasdaq. 

A little bit of background on these penny stocks, these OTC transactions used to be done through the electronic bulletin board known as OTC Bulletin Board or OTCBB for short. This was an electronic quotations service that used to offer traders and investors up to the minute quotes, sales prices, and volume information for equity securities traded over the counter. The companies listed on the platform had to file their current financial statements with the Securities and Exchange Commission (SEC) or a regulator. 

Now, as a warning, the OTCBB is a less than stellar platform to use for trading penny stocks. The reasons being that there are fulfillment issues, you could get stuck in trades, there are delays in timing and other issues. It’s recommended to steer clear of the platform and stick to trading on Nasdaq, which is a lot more reliable of a platform and doesn’t come with the setbacks one would encounter on the OTCBB. 

The OTCBB was started in 1990 after The Penny Stock Reform Act put stipulations in place that stated that the SEC must develop and implement a type of quotation system for stocks that could not be listed on major exchanges. So stocks that traded over the counter were done so between individuals and market makers using telephones and computers. 

Just as it is today, these over the counter stocks were not listed on any major exchanges and primarily this was because of the volatility and size of the stocks. So it was difficult for these stocks to make the listing requirements. What’s even more important is that from a bid-ask spread standpoint, typically, these stocks have a larger bid-ask spread than exchange-listed stocks. This is due to the trade frequency being less than exchange-listed stocks. In fact, only a few OTCBB listed stocks moved from the OTC market to a major exchange. 

In addition to OTCBB, penny stocks can also be traded on privately owned pink sheets. Pink sheets are a listing service for stocks that are traded over the counter. Pink sheet listings are companies that are not listed on major exchanges such as the New York Stock Exchange or Nasdaq. Pink Sheets is also a private company that works with broker-dealers to market the shares of equities they represent. 

Remember the warnings about the OTCBB stated above? Well, those go for pink sheets and more, because pink sheets are a quotation service and not an exchange. Therefore pink sheets are unregulated and that leads to the platform being a scam magnet. There is minimal to no transparency or fundamental information available to investors and that can lead to stocks being subject of various schemes. Pink sheets also disallow margins and short selling, which is a trading strategy that speculates on the decline in stock and other securities pricing. That last point seems to swing viewpoint depending on the investor but it’s best to stick to Nasdaq just in case it doesn’t work for you. One common scheme is the pump-and-dump where promoters buy penny stocks, promote and pump up the prices, then drop those same stocks while the late investors are stuck with worthless stocks that can do nothing for them. You’ll see these stocks being promoted in spam emails and on message boards/blogs. Being stuck with overpaid and useless stocks is not the end goal so be aware and stay within the safe confines of Nasdaq. 

Pink sheets are called as such due to the pink paper that the quotes of share prices were on. Nowadays the trades are no longer on paper but the name has stuck around despite the switch to electronic quotes. Now, not all companies listed on the primary stock exchanges for various reasons. OTC refers to the process of how securities of unlisted companies trade. These investments are traded via a broker-dealer network.

A broker-dealer is a person or firm that buys or sells securities for it’s own account or on behalf of it’s customers. This term is used in U.S. securities regulation parlance to describe stock brokerages because most act as agents and principals. It’s also interesting to note that there are over 3,700 broker-dealers to choose from, so you have quite the pick of the litter. Something to note is that trading in pink sheets is highly speculative so it’s best to understand them. For one, there are risks in trading pink sheet stocks. Like the lack of liquidity and that there is less regulatory oversight. 

Now that we’ve defined the two ways that penny stocks are quoted and traded, let’s focus on penny stocks themselves. Penny stocks used to be defined as any stock that traded for less than a dollar. But now that definition is sort of obsolete because it’s been broadened by the SEC to include all stock that trades for less than $5. Penny stocks are usually associated with smaller companies and they trade infrequently. This leads to them being having a lack of liquidity or ready buyers on the marketplace. A lack of buyers means that investors may find it difficult to sell their stock. And due to the low liquidity, investors may also have difficulty accurately pricing their stocks to reflect the market. 

Which leads to price fluctuations. So, penny stocks offered on the marketplace are most often smaller companies or growing companies that are low on income and resources. So this makes penny stocks great for those who love a good risk and enjoy the potential gain from putting it all on the line. Since you can lose your entire investment on a penny stock, it’s important to take into factor that penny stocks are high volatility. Oh, and one small tip: If you thought losing your own money was bad, imagine being in the red due to a penny stock gone wrong. Some investors will borrow funds from a banker or broker to purchase shares. This is called buying on margin and if things go bad, you end up owing money and that can be even worse than losing money. Make sure you’re in the position to pay that money back before buying on margin. 

So you may be wondering, how are penny stocks created? Well, as a means to raise capital and grow their business, small companies and startups will issue stock. As lengthy as the process of that may be, it’s still an effective way to obtain said capital. The first step of this lengthy process is to hire an underwriter. This is someone usually an attorney or investment banker who specializes in securities offerings. The company would then get their financial statements and proposed sales materials ready because they’d then have to register with the SEC, either under Regulation A or Regulation D if exempt from the former. 

A quick tip to dodge one of the many risks with penny stocks is to pick out a fraud. Since there are no fool-proof safeguards besides having a backup plan, one way to protect yourself out there in the realm of penny stocks is how to spot a fraud. Here are some warning signs. SEC trading suspensions, also known as a trading halt. This typically happens when the SEC detects things like order imbalance, technical glitches, or regulatory concerns. Also, look out for reverse splits. This is a process in which shares of a corporate stock are merged to form a smaller number of proportionally more valuable shares. This isn’t a sign of fraud, however, it could be signs of a struggling company and therefore bad stock.  Another warning sign is large assets with small revenue. If it seems too good to be true, proceed with caution. 

Penny stocks are the perfect example of how being in the stock business can either go really well or really bad. It’s interesting how something that can sell for so little can really break your bank. So have those safety nets in place and make sure you can take the hit if the penny stocks you buy end up blowing up in your face.  

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