Introduction:

A penny stock typically refers to the stock of a small company that trades for less than $5 per share. Though some penny stocks trade on large exchanges such as the New York Stock Exchange (NYSE), most trade via over-the-counter (OTC) transactions through the electronic OTC Bulletin Board (OTCBB) or through the privately-owned OTC Markets Group. There is no trading floor for OTC transactions. Quotations are also all done electronically.

Explained:

In the past, penny stocks were considered any stocks that traded for less than one dollar per share. The U.S. Securities and Exchange Commission (SEC) has modified the definition to include all shares trading below five dollars. The SEC is an independent federal government agency responsible for protecting investors as they maintain fair and orderly functioning of the securities markets. Penny stocks are usually associated with small companies and trade infrequently meaning they have a lack of liquidity or ready buyers in the marketplace. As a result, investors may find it difficult to sell stock since there may not be any buyers at that time. Because of the low liquidity, investors might have difficulty finding a price that accurately reflects the market. Due to their lack of liquidity, wide bid-ask spreads or price quotes, and small company sizes, penny stocks are generally considered highly speculative. In other words, investors could lose a sizable amount or all of their investment.

Price Fluctuations:

Penny stocks offered on the marketplace are often growing companies with limited cash and resources. Since these are primarily small companies, penny stocks are most suitable for investors who have a high tolerance for risk. Typically, penny stocks have a higher level of volatility, resulting in a higher potential for reward and, thus, a higher level of inherent risk. Investors may lose their entire investment on a penny stock, or more than their investment if they buy on margin, which means the investor borrowed funds from a bank or broker to purchase the shares. Considering the heightened risk levels associated with investing in penny stocks, investors should take particular precautions. For example, an investor should have a stop-loss order predetermined before entering a trade and know what price level to exit if the market moves opposite of the intended direction. Stop-loss orders set a price limit that, once reached, will trigger an automatic sell of the securities. Although penny stocks can have explosive gains, it is important to have realistic expectations and understand that penny stocks are high-risk investments with low trading volumes.

Risk:

Penny stocks do provide some small businesses with a way to access funding from the public. These companies may use this platform as a starting block to move into a larger marketplace. Also, since they sell at such low prices, there is room for significant upside. However, some factors exacerbate the risk associated with investing or trading penny stocks. Securities are usually riskier than more established companies known as blue-chip stocks.

Pros:

• Offer a place for small companies to gain access public funding.
• In some cases, penny stocks may provide a method to gain access to larger marketplace listing.
• With a lower price, penny stocks allow for significant upside in share appreciation.

Cons: