Penny stocks are stocks in small cap companies that trade outside the major
exchanges like NYSE or NASDAQ. They are traded over the counter and are
also called OTC or micro cap stocks.
Penny stocks fall into the high risk category of investments because of
the many risks involved with them. These include limited liquidity, lack
of financial reporting, ease of manipulation and fraud. Many of the spam
emails people receive talk about these stocks as a sure fire investment with
guaranteed overnight returns. This is not true; in reality investing in these
stocks requires very careful planning and dedicated research. The various
risks involved are outlined below.
• Incomplete information available to the public. Information
related to micro cap stocks is always more difficult to find. This is
because the penny stocks are for companies that are listed on pink
sheets. This means they are not required to file with the Securities
and Exchange Commission (SEC). They are not open to the public for
scrutiny and are not regulated. It is also very difficult to verify the
credibility of these stocks.
• Lack of a record of past performance. For any stock investment,
it is imperative to check on the past performance of the stock. But in
the case of small or micro cap stocks, the history available is almost
negligible. This is because they are generally offered by companies
approaching bankruptcy or which are new to the market. Thus, there
is a huge risk in investing in a stock that has no credible history.
• Liquidity. Penny stocks do not deal with ranking stock markets.
Instead they are traded over the counter and are thus referred to as
OTC investments. Dealing does not happen frequently so if a need
arises to dispose of the stocks, it is difficult to find buyers for them. If
you cannot sell the stock you are left with little choice other than to
lower the prices until you find a suitable buyer. A low liquidity level
also gives traders a chance to manipulate stock prices.
• No minimum standards. Stocks listed on the pink sheet and the
OTCBB do not have to fulfill certain standard minimum requirements to
remain on the exchange. This is a deterrent for many investors who
deliberately look out for the minimum standards that act as a safety
cushion and a benchmark.
However, penny stocks can give very good returns in the long run if careful
research and planning has been done before buying them. They can be very
profitable if you know what you are doing and you know enough to avoid
the pitfalls. Consulting an expert in the trade before making a decision is
advisable. You will also find many tools and services offered for traders of
these stocks that help you get the maximum benefit out of your investment.
Signing up with a full service online broker is a good idea.