Penny stocks may be ideal for beginner traders because of their low price and the higher rate of risk they carry. First, someone who is new in the world of stock trade may not have the funds to pay the price per share in other securities, and second, the increased rate of risk may just be the right thing for beginners to get a feel of how unpredictable the stock market can get. These two traits of penny stocks are often the reason why so many people trade in them. They are cheap and can be extremely volatile, which suits the gambling types who are looking to get rich overnight.
Definition of Penny Stocks
Any stock rated below $5 per share by the Securities and Exchange Commission may be considered a penny stock. As such, penny stocks are often traded on markets that are not strictly regulated, like the Pink Sheets or Over-The-Counter Bulletin Board (OTCBB). Still, they are not confined to these two markets. Penny stocks have substantial potential for income on securities exchanges, yet they are favored on the Pink Sheets and OTCBB because of less strict regulation, since many companies which end up as penny stocks are experiencing business hardships.
Apart from the Securities and Exchange Commission qualification of penny stocks, brokers often have their own standards for identifying penny stocks. And while some of them define them by their price per share, others will call a penny stock any stock that is traded on the OTCBB or in the Pink Sheets. The truth is that the maximum price will differ from broker to broker. Before starting out with the penny stock trade, you should check on your broker to see how they identify penny stocks, as every trade will be charged an additional fee.
Penny Stock Markets
It was mentioned that penny stocks are predominantly traded in less regulated markets like the OTCBB or Pink Sheets. Over-The-Counter Bulletin Board is a market where you can trade stocks that fail to meet the listing requirements of major stock exchanges like NASDAQ or NYSE. Penny stock companies traded on the OTCBB are by definition relatively small and unknown, and thus perceived as risky. In a similar way, the Pink Sheets can be also used to trade in stocks that do not support the major exchanges’ listing requirements. However, it is even more loosely regulated, since unlike the OTCBB, the Pink Sheets does not require penny stock companies to maintain SEC filings.
The Role of DTCC
The Depository Trust and Clearing Corporation is the body that handles clearing securities for brokers. Your broker should know if a particular penny stock is DTCC eligible, or it was put under a restriction, so make sure you check with your broker every time you are about to buy a penny stock. Otherwise, if a penny stock does not meet DTCC requirements or it is restricted, a trader is charged an enormous amount in fees. Even worse, that penny stock will be extremely hard to sell later on.
Assessing the Risk
Due to the inherently risky nature of penny stocks, it always pays off to research a bit before pulling the trigger. You can learn how to trade in penny stocks in many online guides. Whatever the place or the listed price may be, always remember that the stocks listed in the Pink Sheets or on the OTCBB lack disclosure and are often a façade for various scams. One particular scam is called a pump-and-dump scheme. It is done by purchasing a large amount of a company’s stock, followed by extensive promotion of the company which inflates its stock price. The scam capitalizes by selling the stock at higher price than real.