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What is a 'Penny Stock'

A penny stock typically trades outside of the major market exchanges at a relatively low price and has a small market capitalization. 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 OTC Bulletin Board (OTCBB) and pink sheets.

BREAKING DOWN 'Penny Stock'

The term penny stock has evolved with the market. In the past, penny stocks were stocks that traded for less than a dollar per share. The SEC, however, has modified the definition to include all shares trading below $5.

Most penny stocks don’t trade on the major market exchanges. However, there are some large companies, based on market capitalization, that trade below $5 per share on the main exchanges like the Nasdaq. An example of a penny stock listed on the Nasdaq is Curis Inc. (CRIS), a small biotechnology company. That said, 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.

Things to Remember About Penny Stocks

Penny stocks are more suitable for investors with a 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. Considering the heightened risk levels associated with investing in penny stocks, investors should take particular precautions. 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 deeply disappointed.

Avoid the Pitfalls of Penny Stock Investing

Penny stocks are often growing companies with limited cash and resources. In other words, most penny stocks are high-risk investments with low trading volumes.

To protect yourself, trade penny stocks that are listed on the American Stock Exchange (AMEX) or Nasdaq, as these exchanges are rigorously 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 also often recommended via free newsletters, mailing lists and emails, and are marketed using unscrupulous tactics, such as alluding to get-rich-quick opportunities. These recommendations should be ignored, as the publisher may be wanting to increase a market artificially.

Further, 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.

In short, be wary of penny stocks. The chances of huge profit can be counteracted by even bigger chances of huge loss. Also, don't be fooled by people telling you that companies like Microsoft were once penny stocks. This is a fallacy: Microsoft Corp. never was (and very likely never will be) a penny stock.

 

 
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