A Penny stock mostly refers to the small company stock that trades for less than $5 per share. However, some Penny stocks trade on large exchanges such as the NYSE (New York Stock Exchange). Most trade via OTC (over the counter) transactions, or through the privately-owned OTC Markets Group.
It’s important to mention that small companies and startups usually issue stock to increase capital to boost the business. Though the process is long, issuing stock is often one of the swiftest and most productive techniques for a startup company to obtain capital.
Penny stock: created through an initial public offering or IPO
Like any other publicly traded stock, a Penny stock is created through an initial public offering or IPO. Significantly, to get on the OTCBB, the corporation must first file a registration application. Except for that, the company must also check state securities rules in the locations it plans to sell the stock. After receiving approval, the company may start the process of linking orders from investors. Finally, the company can apply to have the stock listed on a more extensive exchange or trade on the over-the-counter market or OTC.
Any stocks exchanged for less than one dollar per share received labels as Penny stocks in the past. The U.S. Securities and Exchange Commission (SEC) has changed the definition to include all shares trading under five dollars. The U.S. Securities and Exchange Commission is an independent federal government agency liable for preserving investors as they keep the securities markets’ fair and orderly functioning.
Besides that, Penny stocks have associations with small companies and trade infrequently. Thus, implying they lack liquidity or ready customers in the marketplace. Therefore, it is not surprising that investors may find it difficult to sell stock since there may not be any customers at that time. Because of the weak liquidity, investors might have trouble finding a price that correctly reflects the market.
Penny stocks are generally recognized as highly speculative. Investors could lose a substantial amount or all of their investment.
There is a possibility that investors will lose their investment
Penny stocks offered on the marketplace are often developing companies with limited cash and resources. Since these are small companies, Penny stocks are most receivable for investors with a high-risk tolerance. Penny stocks have a higher volatility level. Therefore, there is a possibility that investors lose their whole investment on a Penny stock or more than their investment if they purchase on margin. Purchasing on margin suggests the investor borrowed funds from a bank or broker to buy the shares.
As investing in Penny stocks are risky, investors should take particular precautions. For example, before joining a trade, an investor should have a stop-loss order predetermined and know what rate level to exit if the market goes opposite the expected direction. Stop-Loss orders are instructions set with the broker, which set a price limit that will trigger the securities’ automatic sale once reached.
Penny stocks can indeed have explosive moves. However, it is essential to have realistic expectations. Investors know that Penny stocks are high-risk investments with low trading volumes.
Why is it risky?
As we already mentioned, while there can be substantial gains in trading Penny stocks, there are also equal risks of losing a substantial investment volume in a short period. Lack of information available to the public can be one of the that makes Penny stocks risky. It’s essential with any strong investment strategy to have sufficient information to make a decision. For Penny stocks, information is much harder to find as compared to well-established companies.
Many of the companies considered Penny stocks could be recently formed, and some could be on the edge of bankruptcy. These companies will generally have weak track records or no track record at all. As you can imagine, this shortage of historical information makes it tough to determine a stock’s potential.