What is a Penny Stock?

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Being employed in the securities industry has its fair share of unique and challenging situations. One situation that I always find comical is when a client calls me and wants to buy some obscure penny stock that they claim is the next “sure thing”. Each time this occurs, it never fails that the stock is some random recommendation from the client’s brother’s barber’s son-in-law who guarantees the stock is getting ready to take off. Every time this occurs I always sigh to myself and think, “Sure it is”. Before you go out and try to strike gold let’s find out what a penny stock really is and what risks they have.

Pennies on the Dollars

One would think that a penny stock would cost only pennies, right? Well, not quite. Actually, to qualify as a “penny stock”, the stock price will be less than $5.00. Here are a few other characteristics of a penny stock:

They are not traded on any exchange or the Nasdaq
Priced less than $5.00
Company has not met financial standards of listed equity companies.

Why Are Penny Stocks Risky?

Many investors are attracted to penny stocks because of the buying power (you can buy lots of shares without a lot of money) and “potential” payoff. Keyword is “potential” or better translated as “not likely“. What makes penny stocks so risky is there lack of liquidity. Penny stocks are not traded on the major exchanges (NYSE or Nasdaq) and are traded on Over the Counter Bulletin Board (OTCBB) or the Pink Sheets. The listing requirements of these are far less stringent than the major exchanges, so many of these companies do not have to have as detailed reporting as their publicly traded counterparts.

All these factors combined are what make penny stocks that much more risky.

Liquidity is an Issue

Penny Stocks are Risky

Since these stock are more thinly traded, it can be hard to find a buyer if you hold the stock. And just because the stock may list for a certain price, doesn’t mean that there is a buyer out there. Think trying to sell a Barry Bonds rookie card for what the pricing guide lists it for. Chances are you are not going to find a buyer.

Beware of Penny Stock Scams

Many of us have been exposed to some sort of scam promoting penny stocks. According to a study conducted at Oxford, 15% of all e-mail spam was related to penny stock fraud. According to the study,

“People who responded to the ‘pump and dump’ scam lost 8% of their investment in two days. Conversely, the spammers who buy low-priced stock before sending the e-mails, typically see a return of between 4.9% and 6% when they sell.”

The most common penny stock fraud is the “Pump and Dump“. A small group of speculators will accumulate a large number of shares in a penny stock. Once their positions are in place, they will release positive financial propaganda, news so unexpected and titillating it can drastically affect people’s perception of the stock. The intent is to get small-time investors to start trading irrationally. The news is almost always false, but before this is discovered, the price of the stock often skyrockets and the original speculators exit with large profits.

Beware of Penny Stock Scams

Over the years, I have received countless solicitations at work from cold calling Boiler Room types trying to get me to take a look at a hot stock so that I would call my clients about it. It never failed that this next supposed gold mine was some thinly traded penny stock that was going anywhere but up.

Another example of a scam that I and another blogger Mrs. Micah both experienced was receiving a fax at work involving penny stocks. The fax is made to somebody else’s attention and you are led to believe by the scammers that you have been on the receiving end of inside information by mistake. They are hoping that you will go out and buy the stock and tell all your friends to buy it, too. If you get a similar fax at work, don’t call your stock broker about buying it. Head to the shredder and save yourself the trouble and money.

photo credit: killerturnip