What are Penny Stocks?

Although there is no universally accepted definition of penny stocks, that does not stop people from trying to pin it down. When stocks are referred to as "pennies," this usually means stocks that have a low price and the company has low market capitalisation.

Generalisations can be true or false, but pennies are considered to be risky and highly speculative. Why? Because pennies are usually associated with stocks that lack liquidity. These companies also have large bid-ask spreads, small caps and limited disclosure. The company will also be likely under limited listing requirements and limited regulation.

Some traders say that stocks that trade for under $5 and stocks that trade off the major market exchanges are pennies. But note that there are large cap companies that trade below $5 and there are small cap companies that trade for $5 and above.

Penny Stocks Risks

Companies have to start somewhere, even Microsoft. Penny stock hunters sometimes bet entire fortunes on discovering the next big thing, but their efforts are usually wasted. There are several reasons for this.

• Transparency. An educated investor is way ahead of the uninformed one, obviously. Before buying into any stock, researching the company is a no-brainer. But what if you can't find the information you need to make a decision? You run into this problem with pennies and micro caps. Even if information about the company is publicly available, they are generally from untrusted sources.
• Liquidity. When stocks have low volume activity, you may not be able to sell the stock easily. It may be hard to find buyers for your stock, and you may need to lower your asking price. Low liquidity is also a magnet for fraudsters. One price manipulation method involves buying large quantities of a stock, overvaluing the stock and then selling away when gullible investors take the bait.
• Past Performance. Many micro cap companies are either going bankrupt or newbies. Now, there's nothing wrong with being a greenhorn, but investing in these companies can mean trusting only in gut feel, as there's no history where you can base your analysis on.
• Scams. The number of fleecers increase with opportunities to swindle you out of your money. While not all low-priced stocks are automatically speculative, penny stocks open up your purse to these unsavouries. You may get spam emails promoting a stock, which are actually from companies who pay individuals to market their suspicious product. Others do not stop with email. They will actually cold call you (or potential investors with capital) and use high pressure tactics to take away your money.

To Buy or Not to Buy Penny Stocks

Generalisations do not give justice to micro caps who are working hard to be reputable companies. There are quality stock investments among pennies, but high risk remains an issue. Learn everything you can about the stock and the company if you are set on investing in these micro caps.