Penny Stock

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What is a 'Penny Stock'

A penny stock typically trades at a relatively low price and has a small market capitalization, usually outside of the major market exchanges. These stocks are generally considered highly speculative and high risk because of their lack of liquidity, large bid-ask spreads, small capitalization and limited following and disclosure. They often trade over the counter through the OTCBB and pink sheets.

BREAKING DOWN 'Penny Stock'

There is no generally accepted definition of a penny stock. Some consider it to be any stock that trades for pennies or those that trade for under $5, while others consider any stock not trading on the major market exchanges to be penny stock. However, there are some very large companies, based on market capitalization, that trade below $5 per share, while there are many very small companies that trade over $5. The typical penny stock is a small company with highly illiquid and speculative shares. The company is generally subject to limited listing requirements along with fewer filing and regulatory standards. An example of a penny stock listed on the Nasdaq is Curis Inc., a small biotechnology company.

Things to Remember About Penny Stocks

Penny stocks are more suitable for investors with high tolerance for risk. Typically, penny stocks have a higher level of volatility, resulting in a higher potential reward and a higher level of risk. Practice sound money management principles when considering the heightened risk levels associated with investing in penny stocks. For example, an investor should have a stop-loss order predetermined before entering the trade, knowing where to exit if the market moves opposite of the intended direction.

Although penny stocks can have explosive moves, it is important to have realistic expectations. Typically, gains in the stock market take months and years to materialize. An investor who buys penny stocks with the intention of turning $100 into $50,000 over a week is likely to be severely disappointed.

Avoid the Pitfalls of Penny Stock Investing

Trade penny stocks that are listed on the American Stock Exchange (AMEX) or Nasdaq, as these exchanges are thoroughly regulated. Avoid trading penny stocks that are not listed on a major exchange, such as a stock quoted on the pink sheet system in the over-the-counter (OTC) market.

Don't buy a penny stock based on a tip from a friend; extensively research and conduct due diligence on a company before making an investment. Penny stocks are often recommended via free newsletters, mailing lists and emails, marketed using unscrupulous tactics, such as alluding to get-rich-quick opportunities. These recommendations should be avoided, as the publisher may be wanting to increase a market artificially and sell into it.

Avoid penny stocks that cannot be fundamentally valued. For example, during the height of the technology bubble in the late 1990s, many investors were buying speculative technology companies based on future potential rather than fundamentals.

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