The Risks of Penny Stock Investing

Penny stock investing is considered to be among the riskiest propositions for a stock investor. A penny stock is a stock that trades at a relatively low price (under $5, according to the SEC definition). Penny stocks often trade over the counter (OTC) rather than on any of the major stock market exchanges. The typical penny stock is a very small company with small market capitalization. Many times, it is a new company or a company on the brink of bankruptcy.

Penny stock investing offers low liquidity and the companies are often subject to minimal listing requirements and few regulatory standards.

The Problem of Liquidity

The issue of liquidity is summarized by the SEC, “Penny stocks may trade infrequently, which means that it may be difficult to sell penny stock shares once you own them.” Low liquidity levels not only make it harder to unload the stock, but it can provide opportunities for some traders to manipulate stock prices (as we discuss below).

Minimal Filing Requirements

Unlike the major exchanges (NASDAQ or the NYSE), there are minimal requirements for a stock to be listed on the OTC Bulletin Board (OTCBB). Essentially, they must make their filings with the SEC on time and not much else. Often, companies that are de-listed from the broader exchanges will re-list on the OTCBB or Pink Sheets (another electronic quotation system).

The Spread

Brokerage firms that sell penny stocks generally make their money by charging a mark-up above whatever the price is that the firm has paid for the stock (most brokerages earn a profit through sales commissions). The mark-up charged is not usually disclosed to the investor.

This leads to the issue of the spread, which represents a built-in loss for the investor at the time of the stock purchase. The spreads in penny stocks can be substantial, often 50-100% or more. The penny stock investor, then, is immediately and substantially in the hole.

Artificial Demand

Adding to the risks of penny stock investing is the fact that many penny stocks are traded by only a single brokerage firm that has acquired a large number of shares at a low price. This firm, or a small group of firms working together, can work to create artificial demand for the stock through marketing practices that bring enough attention to the stock to drive up the price. The artificially high price will plummet after the firm sells its shares.

Please note that, for your broker to even sell you a penny stock, they are required to provide you with a document which outlines the risks of penny stock investing.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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