A penny stock is generally defined as a security issued by a small company that trades at less than $5 per share. These are stocks generally quoted over-the-counter, for instance on the OTC Bulletin Board or the pink sheets.
The legal definition of a penny stock is more specific. A penny stock is any security that isn't a National Market System (NMS) stock, registered to trade on a national securities exchange, and with a bid price of at least $4 per share. Other requirements must also be met in order for a stock not to be considered a penny stock. For example, shareholder equity must be at least $5 million, the company must have at least $750,000 in net income, and its market capitalization must have exceeded $50 million for at least one year, among other requirements.
The Securities and Exchange Commission (SEC) requires brokers to provide you with a statement warning of the risks involved with penny stocks before you make your first trade.
Penny stocks are highly speculative. The odds of losing your entire investment in a penny stock are far greater than is hitting a home run and raking in huge profits. Still, millions of people trade penny stocks on a daily basis. Here are 10 types of penny stock investors, whether they're found on the long side, short side, or both.
1. Experienced Penny Stock Traders
Many who thrive in the frenetic world of trading do so by carving out a niche in a specific sector or asset. Penny stocks are one such niche, although the number of traders who trade these stocks is a fraction of those who trade established securities and blue-chip stocks. Experienced penny stock traders aren't deterred by the sector's limited liquidity, its wide bid-ask spreads and its frequent market pricing manipulation. For these players, there's little left to surprise them, even in such a volatile market as penny stocks. They can be day traders or swing traders and they'll take both long and short positions.
2. Corporate Insiders
When corporate insiders such as top management buy shares of their company's stock, it's usually taken as a sign of confidence in the company's prospects. Conversely, when these insiders dump shares, it's often an indication that the company is deteriorating and that its stock price may collapse. This rule of thumb doesn't quite apply to penny stocks, however, as insider activity usually goes in one direction: the amount of selling generally dwarfs buying rates (in part because the company may be approaching bankruptcy). These insiders often help orchestrate manipulations in the penny stock market, having traders artificially drive up volume in a specific stock or group of stocks via such actions as "pump and dump" schemes.
3. Hedge Funds
While many financial institutions are prohibited from trading penny stocks, loosely regulated hedge funds have no such restrictions. That said, most hedge funds won't trade penny stocks on the long side: They far prefer short-selling penny stocks that look to have peaked after being heavily promoted. Penny stocks, although they often do indeed trade for mere pennies, can still be exceedingly dangerous to short because of the risk of a short squeeze. So while the risk-reward payoff for shorting a penny stock is too skewed (i.e., offering a limited reward if the short strategy works and unlimited risk if it doesn't) to be worthwhile for an average investor, the strategy may entice a deep-pocketed hedge fund.
4. Short Sellers
Astute traders know there's more to be made by short-selling penny stocks than by buying and holding them. Unlike hedge funds, however, these traders may lack the capital needed to withstand the occasional short squeeze. So they have to rely on networking and leveraging their experience and market intelligence to identify suitable short targets whose shares will decline precipitously from current levels. These short-selling traders are unlikely to be "contrarian" and short-sell a stock that's rising due to heavy promotional activity. Rather, they may pile on the short positions once the stock begins sinking, hoping to hasten its demise.
5. Newsletter Writers
Some investment newsletter writers will produce glowing reports about certain penny stocks, for which promoters reward them with cash and a chunk of the stock in question. While their stock payment may be escrowed for a certain number of weeks or months to prevent newsletter writers from dumping it right away, they're likely to "sell into strength" once their lock-up period expires.
6. Investor Relations Firms
Investor relations firms often provide services to penny stock companies, such as arranging meetings for management with investors and analysts, tailoring corporate presentations and disseminating press releases. In return, they're often compensated with cash and shares of the company's stock. Unsurprisingly, these firms are likely to be sellers of penny stocks rather than buyers.
7. Market Makers
A market maker is a broker-dealer who facilitates trading in a specific security by displaying bid and ask quotations for a number of shares. Market makers that attempt to provide liquidity to the penny stock market naturally become significant contributors to trading volume. Upon receiving a buy order from a trader, the market maker may either sell shares from its inventory or buy them from the market for onward sale to the investor. Conversely, for a sell order, the market maker may either absorb the shares into its inventory or immediately dump them into the market.
Speculation is the lifeblood of the penny stock market. Yet before any major selling can commence, a great deal of buying has to take place to inflate a penny stock's price. And much of this buying comes from long-term speculators who are well-versed in the game and have profited from successful penny stock trades in the past. These players continue to speculate in the hope of repeating earlier successes, but there's usually a limit: Those who incur steep losses will likely stop trading penny stocks after long.
9. Ordinary Investors
Even experienced "traditional" investors will occasionally succumb to the lure of making a quick buck from a supposedly hot tip on a penny stock. It could be a friend or acquaintance who professes to be on the inside track with the penny stock's promoters, or the investor might be convinced by a skilled newsletter writer who has crafted a solid-sounding investment angle. These investors may dabble in the penny stock market once or twice but once they sustain some losses, they're likely to call it a day and stick to trading what they know best: blue chips and senior securities.
10. Inexperienced and Unwary Investors
Then there are neophyte investors who believe they can strike it rich in penny stocks. They're entranced by the idea of buying 10,000 shares of a 10-cent stock for only $1,000 and, once this 10-cent stock hits just 15 cents, they'll have made a neat 50% return on their investment. The hard reality, however, is that such a pricing move is quite uncommon. Even if it does occur, wide bid-ask spreads and limited trading liquidity often prevents the investor from making a quick sale to close their position and lock in profits.
The Bottom Line
Plenty of people trade penny stocks daily, but remember that the number of penny stock sellers dwarfs that of buyers, and that only the experienced survive for long in the sector. If you do yield to the temptation to try your luck in penny stocks, you should treat your investment as a very short-term trade rather than as any sort of long-term strategy.