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Penny stock

A Penny stock is a loosely defined term that can be used in reference to any stock trading at prices below $5 per share .

Contents

Expanded Definition

The term "penny stock" is most commonly used to refer to stocks of companies with very small market capitalizations that trade on The Over the Counter Bulletin Board or the Pink sheets, although technically it can cover any stock under $5 per share.

The Securities and Exchange Commission has special broker requirements for penny stocks, including the requirement that brokers who wish to offer penny stocks to their clients must give special warning to them of the danger of investing in penny stocks [1].

Penny stocks are not typically covered by Wall Street analysts or mentioned in business media.

Criticism

Penny stocks are often criticized for being risky investments, and for good reason. They typically are thinly regulated, have to meet less rigorous listing requirements, can have questionable business practices, and can be very illiquid.

The speculative nature of their shares coupled with the lack of oversight and media exposure can make penny stock vulnerable to stock manipulation schemes such as pump and dump. [2]

Most penny stocks do not ever shed penny stock status. [3]

Pump and Dump Scams

Penny stocks can be vulnerable to stock manipulation schemes such as pump and dump. This scam works by popularizing a stock so that demand goes up, the price goes up, and then all efforts at holding the price up are halted and the stock price crashes. The only ones who benefit are the ones who owned the stock before the scam started, as they sold to suckers who bought as the price climbed and now hold shares worth a lot less than what they bought.

There is also the less common short and distort scam. Their small size and lack of exposure to analysts and the business media can make them an easy target for criminals to manipulate these stocks. Penny stocks are frequent targets of such scams.

Scammers typically employ paid mailers, fax blasts and/or spam stock touts in ensnaring their victims. [4]

If you ever receive an email that claims to give you the name of a company or stock that is supposed to double or triple within the next few days, quickly delete it and ignore it, as it is likely a scam, such as a pump and dump.

You've got the Power!

We understand the fascination with being able to control thousands of shares of a company for a relatively paltry investment, and if they'll only just run up a few nickels or dimes in value, you'll end up with a terrific score. Unfortunately, the fact is there are very few such penny stocks that will do that for you and trying to time the point where they'll suddenly turn south on you is extremely risky.

That's why we recommend investors, new and seasoned alike, stay far away as possible from penny stocks. Most are untried, unproven, and most likely unprofitable ventures.

Here's one penny stock example, looking at it more closely.

More power here:

We prefer to have all of our money working hard for us. While most (or at least many) investors have taken a flier on some speculative venture, us included, we've since come to realize we weren't investing but were instead gambling. And the odds of winning were worse than the roulette wheel.

Much better to focus our attention on choosing stocks in companies with proven business models. Companies that have a history of making products or offering services that customers have shown they need and want, and most important, are willing to pay for. That doesn't mean you're stuck buying utilities or some other staid company (though they're not such bad investing ideas either), but it means not looking amongst penny stocks for our next investment. There may be a handful of stocks that would meet our criteria hiding amongst the weeds of the pennies, but they're so difficult to find and the odds of it actually turning out to be a success are so slim that we and you can more productively spend time elsewhere.

While someone might be willing to take a very small position for the most speculative portion of their portfolio on the hope that Sunrise wins all of its fights (or some other extremely long shot), they'd have to realize that what they're doing is not investing but gambling. That's not how we invest, nor is it how the Motley Fool recommends its subscribers invest either.

To prove this, two of our employees started and run the TMFStockSpam tracking player on CAPS. This player calls "underperform" (vs. the S&P 500) on penny stocks touted in various emails, advertisements, and other venues pushing the company. This strategy has led to TMFStockSpam being one of the most successful players in CAPS, ranked within speaking distance (that's closer than shouting distance) of being #1.

Common Misconceptions

For some reason, many people believe that owning a lot of shares, in the thousands, is worthwhile or it makes them feel like a bigshot. "I own 100,000 shares!" Big deal. If the share price is two cents, you've got a grand total of $2,000 invested. A single share of most other companies hold more value.

Another wrong belief is that it is "easier" for a stock to move its price from $0.50 to $1.00. "It's only a 50-cent move!" they rationalize, looking at all the movements of more respectable companies where 50 cents is nothing. What is overlooked is that this move is a 100% move, and it is the rare company indeed that can double its value (especially for something that is basically worthless to begin with) in a short time (or sometimes even a long time). A 100% move is required, whether the stock price is $0.50 or $35.

Many investors consider penny stocks to only include small market cap companies, however the Securities and Exchange Commission defines Penny Stocks as: "The term 'penny stock' generally refers to low-priced (below $5), speculative securities of very small companies. While penny stocks generally are quoted over-the-counter, such as on the OTC Bulletin Board or in the Pink Sheets, they may also trade on securities exchanges, including foreign securities exchanges. In addition, penny stocks include the securities of certain private companies with no active trading market." [5]

Some investors mistakenly believe many traditional stocks that are large stocks today by market capitalization to have been penny stocks in the past. This error usually occurs if one forgets to factor in stock splits into a stock's past price. [6]

Day Traders

Despite their inherent risks as long term investments many daytraders like to trade penny stocks, due to their volatility and perceived potential for a quick profit. Notable Penny stock traders include Timothy Sykes and the CAPS player EverydayInvestor .

David Gardner Explains

Related Terms

Recent Mentions on Fool.com

Relevant External Links

  1. SEC website
  2. "A memorable Pump and Dump" at Goode Value
  3. New York Times blog
  4. "A memorable Pump and Dump" at Goode Value
  5. SEC definition of a penny stock
  6. New York Times blog
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