What is a penny stock?

The term penny stock has changed over the years. There are many different definitions of penny stocks.

The most common is the official sec.gov definition of a stock that is priced at less than $5. In the past the SEC classed all shares below $1 as penny stocks.

Another common definition is any stock that is traded outside of the major US stock exchanges NYSE, NASDAQ and AMEX.

Investing in penny stocks is a high risk investment

There is no doubt trading penny stocks can be very risky indeed. Due to the lack of liquidity of many of these stocks, spreads can be huge, often as high as 10%!

This means your stock has to appreciate by 10% just so you can pay the spread!

Traders may find the idea of trading penny stocks appealing because of the potentially extreme volatility and potential for humongous returns, several hundred percent in a week is not uncommon.

The unfortunate thing is the the majority of penny stocks end up worthless and lose all their value. It reminds me of the old saying for every winner there are a million losers.

Penny Stock Manipulation

The lack of liquidity makes penny stocks very vulnerable to manipulation which can result in extremely volatile price movements and can make them very difficult to predict which direction they will go in. The SEC warns penny stock traders to fully educate themselves on penny stocks extensively before trading.

Selling penny stocks

Selling penny stocks can be difficult at times. Unlike the major exchanges where there are huge amounts of buyers and sellers, there may not always be a willing buyer when you want to sell your penny stocks.

Regulation

One big different between regular stocks and penny stocks is the lack of regulation. Penny stock companies do not have to produce audited accounts, so an investor often has little information on the important financial of the company in question.

How are penny stocks traded?

Unlike the major stocks traded on the NYSE and the NASDAQ, penny stocks are on an over-the-counter listing services.

Brokers can use these listing services to publish the bid/ask prices. OTC listing services are not stock exchanges. Companies on them are not required to file financial statements to the SEC.

The two major OTC listing services are Pink Sheets and OTC Bulletin Board.

Beware of penny stock fraud

I don’t know about you, but I have had many spam emails in the past telling me how I can get rich buying a particular penny stock.

Of course, you would be right for thinking they are a con. As with most things, if it sounds to good to be true, it usually is.

Pump and Dump

Pump and dump is a fraudulent strategy where a small group of speculators (or con men!) buy a large quantity of a particular penny stock.

They then create “buzz” by releasing some form of positive statement to encourage people to buy the stock so the price becomes inflated. The con men who bought the stock cheap at the beginning can sell the stock at the higher price, often making a substantial profit. After they sell their stock, the price usually crashes down and the investors who were conned into buying the stock usually face big losses.

Stocks that are the subject of pump and dump fraud are sometimes referred to as “chop stocks”.

Poop and Scoop

Poop and scoop is the opposite of the pump and dump fraud. Con men release false negative statements about a company with the intent of sending the stock price crashing down. After the crash, they then buy the stock very cheaply.