These investments are often in small companies just getting started. To an active investor, they might seem very attractive, offering a huge potential upside for a price well under what one might find on the NASDAQ or NYSE.
However, penny stocks are not worth the risks associated with their trading.
What Are Penny Stocks?
Penny stocks, also sometimes referred to as “microcap stocks,” are defined by the Securities and Exchange Commission as those that trade for less than $5. They may also have a market capitalization anywhere between $50 million and $300 million, according to Investopedia.
These stocks are typically traded through a broker or a dealer on over-the-counter (OTC) markets such as OTCBB and OTC Pink. Investors are typically attracted to them because share prices are often under a dollar. With this market environment, an investor can buy into a company and gain a lot more shares with a small investment.
So What’s the Risk?
Companies with fewer than 2,000 investors or less than $10 million in assets generally don’t have to file with the SEC. Many of the companies that trade on the OTC markets fall into this category.
Because of the more relaxed government reporting requirements, it can be hard to find publicly available information that could be key to deciding whether something is a good investment.
The SEC also warns investors to be wary of fraud, as the lack of available information can make it easy for a con artist to spread misinformation. A common scheme involves talking up the stock so the share price rises and an investor can quickly sell while the price is inflated (a so-called “pump and dump”).
Also, although an investor can buy in cheaply, the stocks are still subject to market volatility. If you buy 1,000 shares of Company XYZ at $1 and the next day the price drops to $.50, the investor has just lost $500. Investors sometimes see only the upside and overexpose themselves to risk.
The SEC lists several things an investor can do to try and check out a potential investment:
- Ask the company if they file with the SEC; they probably won’t hesitate to tell you.
- Contact your state securities regulator to see if they have more information.
- Take advantage of other government regulations. For example, banks must file updated information with financial regulators.
- Look for information within magazines dedicated to finance and corporate profiles.
According to the SEC, things that should raise suspicion include company insiders owning large amounts of stock, SEC trading suspensions and auditing issues such as not having a report signed by a certified accountant.
Finally, there is no safety net. If you feel you’ve been taken for a ride, you can file a complaint with your broker. Eventually, you may end up taking the ultimate step and filing a complaint with the SEC. Unfortunately, they probably won’t be able to help you.
“In many cases, the firm denies wrongdoing, and it comes down to one person’s word against another’s,” according to the SEC website. “In that case, we cannot do anything more to help resolve the complaint. We cannot act as a judge or an arbitrator to establish wrongdoing and force the firm to satisfy your claim.”
An investor looking to get in early on a company in hopes that it will make waves might find that penny stocks are more trouble than they’re worth.
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