Penny stocks have a fairly broad definition, but in general penny stock are defined as low-priced stock issues, often highly speculative, selling at less than $5 a share (according to the SEC). Usually they are called penny stocks because they are not considered of much value, however, some penny stocks have developed into investment-caliber issues.
Other definitions of penny stock includes a low-priced, high risk, common stock that has a short or erratic history of revenues and earnings. A penny stock usually sells for under one dollar and is highly volatile.
Other parts of the definition includes that they are shares that do not trade on NASDAQ nor on any stock exchange, rather they trade on the pink sheets. Which means penny stocks can also be defined as a low priced stock, traded in over the counter markets.
No matter how you want to define it, penny stocks are shares of very low market capitalization trading in multiples of just a few pence. Penny shares tend to be very volatile, subject to extreme price fluctuations on the flimsiest of rumors, and are far riskier than larger shares.
Many people think that because the shares cost less per share, that they are less risk. They put less money into them, so the risk must be less, but the truth is, the low price lures people in, and because of the volatile nature of the stocks, and the many price fluctuations, truth is people tend to lose much more money in penny stocks than they do with larger shares. These stocks are risky.
What’s the Problem with These Stocks? What makes penny stocks risky?
Well, there are four major issues that arise when you decide to buy these securities:
- Lack of Information Available to the Public
Making a successful investment requires having enough tangible information to make informed decisions. For penny stocks, information is difficult to find because companies listed on the pink sheets are not required to file with the SEC.Also, most of the information out there about penny stocks is typically not from a credible source. - No Minimum Standards
Stocks traded on Pink Sheets do not have to fulfill minimum standard requirements to remain on the exchange. This is tragedy, because minimum standards act as a safety cushion for some investors and as a benchmark for some companies. So, it makes them much more risky. - Lack of History
Most penny stocks are either newly formed or approaching bankruptcy. Most penny stock companies have a poor track record or none at all. Which makes picking the right penny stock difficult. - Liquidity
When stocks don’t have much liquidity two problems arise: number one, there is the possibility that the stock you purchased cannot be sold, or that you will have to lower your price until it is considered attractive to another buyer. So, basically you could lose money very easily. Number two, low liquidity levels often opens the penny stock up to scammers. It provides opportunities for some traders to manipulate stock price, hype it up and then sell it after other investors find it attractive, this is often called pump and dump.
As you can see there are some major risks and problems associated with penny stocks.