What are Penny Stocks ? Definition , Risk , Volatility, Trading and More 2024 Edition

What are Penny Stocks ? Definition , Risk , Volatility, Trading and More 2024 Edition
Image by Nattanan Kanchanaprat from Pixabay

What are Penny Stocks ?

Penny stocks are shares of small public companies that trade for less than one dollar per share. According to the U.S. Securities and Exchange Commission (SEC), penny stocks are any shares trading for less than $5 per share.

Unlike major stocks listed on big exchanges like the NYSE, penny stocks are traded over-the-counter (OTC) , which means they are bought and sold through a network of dealers rather than on a centralized exchange.

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Penny stocks are called that because they used to cost just a few cents each. These stocks are for small companies and can be very risky to buy because their prices can change a lot and they are not very stable.

They were classified by the SEC in 1934 when the U.S. government introduced regulations to control the trading of securities, especially those trading for less than $5 per share, preventing them from being listed on major stock exchanges.

Where Penny Stocks Traded ?

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Image by Milly from Pixabay

Penny stocks are often traded on Over-the-Counter ( OTC ) exchanges like:

OTC Bulletin Board: Managed by FINRA.

OTC Link LLC: Operated by OTC Markets Group, Inc., previously known as Pink OTC Markets Inc.

Securities Exchanges: Penny stocks can also be traded on securities exchanges, including those outside the United States.

Some penny stocks may represent securities of private companies that don’t have an active trading market.

What are the Risks and Investment Considerations for Penny Stocks ?

Penny stocks are associated with small companies that have low market capitalization. Market capitalization (market cap) is the total value of all a company’s shares combined.

Because penny stocks are cheap investors can buy a large number of shares for a relatively low amount of money. This often leads to higher volatility in the penny stock market.

Volatility Rate in Penny Stocks

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Image by Mohamed Hassan from Pixabay

Volatility measure how much a stock’s price increase or decrease. High volatility means the price changes frequently, making the investment riskier. Low volatility means the price is more stable and generally safer.

Penny stocks tend to have high volatility, meaning their prices can swing dramatically. This is due to their low price and small market size, causing more rapid and significant price changes compared to larger, well-established stocks.

Possibility of Fraud & Risks in Penny Stocks ?

Fraud is a significant issue in the penny stock market, with the FBI and prosecutors noting widespread problems. Even small companies can be involved in scams that result in substantial financial losses.

Low Liquidity Issue: Penny stocks often suffer from low liquidity, making it difficult for investors to sell their shares. This lack of liquidity can complicate cashing out positions and affect pricing.

Studies indicate that while small market cap and low liquidity can increase risk, they also offer potential for higher returns due to size and liquidity premiums.

Regulation: In the U.S., the SEC and FINRA have specific rules to regulate and oversee the trading of penny stocks to help protect investors.

What are Some Concerns for Investors in Penny Stocks ?

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Image by Mohamed Hassan from Pixabay
  • Lack of Information: Penny stocks often come with limited information about the companies issuing them. This lack of transparency makes it difficult for investors to make informed decisions.
  • Due to the thin market and limited public reporting, penny stocks are prone to manipulation. Stock promoters may buy large amounts of stock and then spread false or misleading information to drive up the price.
  • A common fraudulent practice is the “pump and dump” scheme. Manipulators artificially inflate the stock price by creating hype. Once the price has risen and liquidity increases, they sell their shares at a profit, leaving other investors with devalued stock.

Regulation of Penny Stocks

assumed to have total assets worth of Approximately $3.9 trillion

In the U.S., penny stocks are defined based on specific criteria such as price, market capitalization, and minimum shareholder equity. Stocks traded on major exchanges like the NYSE are not considered penny stocks, even if they trade below $1 due to lower manipulation risk.

Historical Context: The regulation of penny stocks began with State securities laws. Georgia was the first state to introduce a comprehensive penny stock law, driven by Secretary of State Max Cleland and Representative Chesley V. Morton. This law was later upheld in court and became a model for other states.

The SEC and FINRA now enforce detailed rules and regulations for penny stocks. These regulations aim to protect investors and ensure fair trading practices.

The regulations have successfully shut down or restricted many penny stock broker/dealers, such as Blinder, Robinson & Company. Meyer Blinder, a prominent figure in penny stocks, was jailed for securities fraud in 1992 following his firm’s collapse

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