What is a Penny Stock?

A penny stock is usually traded outside of the principal market exchanges at a comparatively low price and bears a small market capitalization. These stocks are usually highly speculative and have high risk due to less liquidity, big bid-ask spreads, little capitalization and limited following and disclosure. They sometimes traded OTC via OTC Bulletin Board (OTCBB) and pink sheets.

How Does a Penny Stock Work?

Previously, the penny stocks were the stocks traded for less than a dollar per share. However, the SEC, changed the definition and included all the shares being traded trading below $5. Most of the penny stocks are not traded on the mainstream market exchanges. However, there are certain large companies, as market capitalization, that trade less than $5 per share on the key exchanges like the Nasdaq. An example is Curis Inc. (CRIS), a small scale biotechnology company. That said, the standard penny stock is a small scale company having highly and speculative shares. The company is typically subject to limited listing requirements with fewer filing as well as regulatory standards. Penny stocks are good for the investors who are willing to take high risk. Usually, the penny stocks are highly volatile, with potential for higher potential reward as well as bear a higher level of risk. Taking into an account the high risk levels related to the investing in penny stocks, investors must consider some precautions. For example, they must pre-determine the stop-loss order before they enter the trade, and know where to exit if the market is not going in an intended direction. Investors entire investment can be lost on a penny stock, if they purchase on margin. Although penny stocks are prone to explosive moves, investors must have realistic expectations. Generally, gains in the stock market consume much time, even years sometimes, to materialize. An investor purchasing penny stocks with the aim of turning $100 into $50,000 over a week might be deeply disappointed. Penny stocks are usually flourishing companies having limited cash and resources. In other words, most of the penny stocks are the high-risk investments having low trading volumes. To protect themselves, investors trade penny stocks only that are listed on the American Stock Exchange (AMEX) or Nasdaq, since exchanges are highly regulated. Following are the factors that make these securities riskier than the blue chip stocks.

Lack of Information Available to the Public

The successful investment strategy needs complete tangible information as it helps make informed decisions. For the micro-cap stocks, information is very hard to find. Companies that are on the pink sheets are not under obligation to file with the Securities and Exchange Commission (SEC) and are therefore not as publicly regulated or scrutinized as the stocks shown on the New York Stock Exchange and the Nasdaq. Moreover, much of such information available regarding micro-cap stocks is not from the credible sources.

No Minimum Standards

Stocks over the OTCBB and pink sheets are not required to meet minimum standard requirements to be on the exchange. Often, this is the reason why the stock is on one of these exchanges. Once a company is unable to maintain its position longer on one of the key exchanges, the company then moves to one of such smaller exchanges. While OTCBB does demand companies to file regular documents with the SEC, the pink sheets don't have any such requirement. Minimum standards are the safety cushion for few investors and as a benchmark for few companies.

Lack of History

A lot of companies that are termed as micro-cap stocks are either those approaching bankruptcy or newly formed. These companies usually have poor track records or even none at all. Due to the absence of historical information, it is hard to know the stock's potential.

Liquidity

When stocks are not having liquidity, it leads to two issues. first, they have least possibility to be sold, as the buyer is hard to find for a particular stock, and the stock might need to be lower in price till anyone becomes interested to buy it. Second, due to low liquidity levels, there are the opportunities for few traders to control the stock prices in various ways; the easiest is to purchase huge stock amount, hype it up and then sell it once other investors are interested (also called pump and dump). Signs of Fraud Though penny stocks don't have any fool-proof protection, the SEC suggests investors to be aware of the following warning signs: SEC trading suspensions, huge assets but little revenues, spam, financial statements having unusual items in the footnotes, odd auditing problems and insider ownership.

How Is a Penny Stock Created?

Like any publicly traded stock, penny stock is created via process called initial public offering, or IPO. First, a firm files a registration statement in the Securities and Exchange Commission or file mentioning that the offering qualifies for a registration exemption. It should consider the state securities laws to plan its stock selling. Then, once approval is obtained, the company can start the process of asking for the orders from investors. Finally, it can apply for listing its stock on the exchange, or it can trade them over-the-counter market, or OTC. Small startups and companies usually issue stock to raise capital for business expansion. Though it is a lengthy process that involves tons of paperwork and is also costly, issuing stock is often one of the best ways for a startup to raise necessary capital. Penny stocks are often the created due to such ventures and can make for lucrative but risky plays for the investors. Like in case of other offerings, the first action is to hire an underwriter, generally an attorney or the investment bank expert in securities offerings. The company needs to register its service either with SEC under Regulation A of the Securities Act of 1933 or under Regulation D if exempt. If the registration is required, Form 1-A; a registration statement,is to be filed with the SEC, along with financial statements as well as proposed sales materials of the company. These financial statements should remain available for public review, and timely reports are also to be filed with the SEC to have the public offering. Once SEC approves, the orders for shares can be solicited from public by related sales materials and disclosures, like prospectus. After investors purchase the initial orders and stock, a registered offering may start trading in the secondary market through listing on the exchange such as NYSE or Nasdaq or trade OTC. A lot of penny stocks are traded in OTC markets because of the firm requirements for listing on the main exchanges. Most of the penny stocks though do not fulfill such requirements, and the companies usually are unable to afford the heavy cost and strict regulations involved. Often the companies create additional secondary market offering once the IPO end. This dilutes the present shares, giving company a chance to get more investors and thus increased capital. It is to be noted that companies issuing the penny stock must plan to gain value in its shares as they are traded in the open market. Moreover, it is compulsory that companies keep providing the the updated financial statements publicly to keep the investors well informed and maintain their ability to quote on the OTCBB.

The SEC's Rules for Penny Stocks

Penny stocks are highly speculative investments. To protect the investors interest, the SEC and the Financial Industry Regulatory Authority (FINRA)define certain rules for regulating sale of penny stocks. All broker-dealers must comply with Section 15(h) of the Securities Exchange Act of 1934 along with all the rules that are required to meet to be eligible to impact any transactions in penny stocks. (1) Sales Practice Requirements 240.15g-9 Before impacting any transaction, a broker-dealer is required to approve the the investor's transaction, meanwhile, the customer should enter the written agreement with the broker-dealer for the same. This practise helps avoid fraudulent and manipulative practices that may be involved in such investments. Approving the customer fundamentally implies checking his feasibility for the investments. Approval are based on the evaluation of the customer's investment experience, goals and financial position. (2) Disclosure Document 240.15g-2 A broker-dealer has to give a standardized disclosure paper to the customer. The paper or document defines the risk factor of investing in the penny stocks, ideas and info about penny-stock market, broker-dealers' duties for the customers, customer rights, remedies if any fraud happens and other important details that can be of interest of the investor. The investor should be well-communicated to read the entire document carefully to make informed decisions. (3) Bid-Offer Quotations Disclosure 240.15g-3 It is compulsory for the broker-dealer to reveal and later confirm the existing quotation prices as well as corresponding information to his customer before initiating any transaction. This helps track the price movement within the market. (4) Compensation Disclosure 240.15g-4 Through this rule, the investor knows about the earnings made by the broker-dealer from a specific transaction, helping him determine if the broker-dealer has a personal interest to initiate a certain transaction. (5) Monthly Accounts Statements 240.15g-6 A broker-dealer is under obligation to send to its clients a monthly account statement, mentioning details like the identity and number of each penny stock in customers account; the transaction dates; purchase price; and the anticipated market value of the security (as per the latest bids and purchase prices). Such statements should also define the limited market for the securities as well as the estimated price in such a market. In cases of no affected transactions in the customers account within six months, the broker-dealer is exempted to provide monthly statements. However, quarterly statements should be sent to the client by the broker-dealers.

After-Hours Trading With Penny Stocks

Investors can trade penny stocks after trading hours. In fact, several biggest market movements, both on the penny stock exchanges and national public exchanges have been seen after hours. These stocks are listed on the listing services like OTCBB and Pink Sheets. For such trading of penny stocks, the investor would buy those shares via normal brokerage service, similar to investing in usual public securities. As many significant movements seem to occur after the exchanges close, penny stocks may have volatile fluctuations after hours. The investors may either sell shares for a very high price or buy at very low price. It is to be noted that even the best penny stocks ar prone to low liquidity and poor reporting. Even if a penny stock does rise after hours, and if the investor wishes to sell, it might be very difficult to acquire a buyer. Penny stocks are not traded frequently, even more so after market hours, which makes it hard to trade penny stocks after trading hours. This, along with poor reporting, makes it difficult for the investors to determine the up-to-date quotations on penny stocks, leading to inaccurate pricing, giving penny stock investors pause and delay the purchase process, especially after trading hours.

When Is a Penny Stock Not a Penny Stock Anymore?

There are various events that drive the transition of a penny stock to a regular stock. The company may issue new securities in the offering registered with the SEC, or may register a present class of securities with the regulatory body. Both kinds of transactions automatically need the firm to comply with the periodic reporting, including the disclosures to investors regarding the business activities, company management, financial condition unless there is any exemption. These filings include 10-Q quarterly reports, annual Form 10-K as well as Form 8-K reports, detailing significant and unexpected events. In some cases,, there are some more conditions requiring the company having at least 2000 investors, or over 500 non accredited investors or over $10 million worth of assets, or all, to file these reports with the SEC. Businesses listing their securities on national security exchange, such as NYSE or the NASDAQ, have to file as well. Lastly, if company has quoted its security on OTCBB or OTCQB, SEC registration is compulsory. Generally, businesses having $10 million or less in assets and less than 2000 recorded shareholders are not required to comply with the SEC reporting guidelines.