What You Need to Know about Penny Stocks

​Penny stocks excite many investors and traders. When looking at past prices, many think they’re able to get a good deal on a stock at a 90% discount to its high. In reality, most who bet on these stocks, will lose. 

At many brokerage houses, penny stocks are considered to be stocks that trade below $5, can’t be bought on margin, and also can’t be sold short. (There are brokers, often offshore ones, who allow for that.)

In common terms, penny stocks are shares of companies that trade below a dollar, therefore are worth pennies.

Penny stocks are shares of companies that have fallen from grace, or where bad companies to begin with. Many of these companies were delisted from NYSE or NASDAQ and trade on a bulletin board (OTC BB) or pink sheets. There are various reasons for delisting. 


​​​Penny stock manipulation

These stocks can also be subject to stock manipulation. If a company wants to issue shares, the higher the price the better. The same applies if insiders and key investors want to sell their shares. Not every stock manipulation is illegal. There are ways to pump and dump shares legally. For instance, a company may have some minor news, and then blow it out of proportion. Many companies also hire stock promoters who hype the news and the company. This often comes in the form of emails sent to investors, online stock recommendations, and stock picking websites. In the U.S., these promoters need to put disclaimers on their materials, but they don’t have to be highly visible.

Penny stock trading

In addition to investors, there are also penny stock traders who enter and exit quickly as even mostly worthless stocks fluctuate in value. For example, a stock trading a $0.005 (half a cent) can rise to $0.01 (one cent). The rise equals half a penny, but also represents a 100% increase. Trading penny stocks is a risky business, but there are traders who can profit from it.

Some traders follow sites that track penny stock promotions. Their strategy is to buy early during such promotions and sell higher to naïve investors. There are also strategies that rely on breaking news and momentum.

A few traders short sell these stocks, which is betting on price declines. For example, when a penny stock starts falling after reaching a peak, these traders bet on price returning to a previous level. At times, penny stocks can rise few hundred percent and then drop rapidly.

This, however, is a risky strategy, as such a stock can continue rising. For example, if a stock rises from $0.01 to $0.05, it may as well go to $0.20 rather than back to $0.01, especially if a stock promotion is strong and/or there are really good news (such as a major contract for a company).

Penny stocks are highly volatile, especially those with relatively low floats. This can work for you or against you.

And here's your chance to learn penny stock trading from a top gun trader who has made millions doing it.

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One could be a bankruptcy filing, and another the inability to keep the stock price above $1 for certain number of days. If the issue is price below a dollar, companies get certain number of days to comply before delisting. Often, these companies will reverse split, which is basically reducing the number of shares in order to increase the price.

For example, you have 1,000 shares of a stock that trades at $0.50. If there’s a 1-10 reverse split, the price of a share will be increased to $5, but you’ll end up with 100 shares. From a technical standpoint that shouldn’t make a difference, but investors tend to strongly dislike reverse splits. And that can lead to further price collapses. You can check stock split history here or by looking at company’s announcements.

Another reason why a company may be delisted is because it didn’t file required reports with the Securities and Exchange Commission (SEC). An example of such a report is 10-K (annual report). In that case, the stock may end up on the pink sheets, which is the very bottom of the exchanges.

Penny stocks tend to be horrible long-term investments (although there are exceptions). The main reason is that these companies keep on issuing new shares to stay alive. This greatly dilutes ownership. Then, stock price of such a company declines, then a new round of financing comes, which leads to further declines. Then, a reverse split happens, and the cycle repeats.

Penny stocks: don't get your hopes too high and watch out for hype