Investing in penny stocks

A penny stock is a low-priced, typically less than $5, common stock, which trades in over the counter markets (OTC) and not on any of the major exchanges such as NYSE, NASDAQ or AMEX. Typically penny stocks represent share in small companies, with market capitalization under $50 million. However, they represent a great percent of the daily trading volume.

Listing requirements for penny stocks are the minimum. However, the lack of minimum accounting standards, change in notification of ownership of shares, and reporting of other material changes affecting the financial viability of a company, actually leave investors unprotected.

Penny stocks are a high risk investment. Investors consider penny stocks as a way to speculate about the market because of their low price and growth potential. Speculation is based on penny stock companies having lower available information about their operations, minimal revenues, unproven management, and often an unproven product or industry. For example, big companies such as Coca Cola have minor speculative value.

It is not possible to calculate the actual worth of most penny stocks. Some do not have inventories, a revenue stream, or even a proven product. The shares rise and fall based on buying and selling demand, and that demand is driven mainly by waves of speculation. By their nature, it is nearly impossible to know what price a penny stock share should be trading at, and conventional financial ratios and industry comparisons are rarely effective measures for realizing a penny stock's tangible value.

Penny stocks have very limited liquidity because they have fewer shareholders and they do not trade the same amount of shares that large companies do per day. Penny stocks are also extremely volatile because the risk is not allocated among numerous portfolios like it happens in stocks with high market cap. Penny stocks often experience dramatic price swings, and often these moves are the result of a large buy or sell order. It is not unusual to see a drop of 20% or 50% during a trading and even return to their original starting point by the end of that same day. Lack of liquidity makes penny stocks difficult to sell and/or to short because the number of buyers is small. Moreover, the lack of financial reporting makes penny stocks vulnerable to manipulation, particularly those with low volumes traded over the counter.

Penny stocks do better in niche markets. Lacking the resources and capital the large companies have, as well as name recognition for their product or service, penny stock companies avoid entering a pre-existing market that is already driven by a dominant force. Typically, penny stock companies perform best in niche markets.

On the other hand, picking the right penny stocks can assist average investors, who are not extremely experienced, to realize great profits. The trick is to protect investment in a way that ensures the gains more than offset the losses.