The Risks of Penny Stocks

Over the last few decades, smaller stocks called “penny stocks” have slowly gained a bad reputation. While there are hundreds of fly-by-night companies and shell companies that many unscrupulous business people have used to make money off of the uninitiated, there are thousands of great, small companies that qualify under the label “penny stocks”.

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The current term “penny stock” usually denotes any publicly traded stock that is currently trading under $5 per share. A majority of these are traded either on the OTC Bulletin Board, Nasdaq or the Pink Sheets. Most investors are familiar with Nasdaq. The Bulletin Board and Pink Sheet markets are “Over-The-Counter” (OTC) quotation systems which brokers use to trade stocks between themselves and for their clients. The old term “Over-The-Counter” is just a traditional way of describing trading that is not done on a major exchange and is traded between individuals connected by telephone or computer networks.

There are three main reasons why companies will be listed on these OTC markets:

1. The company is new or small and unable to meet the initial listing requirements of the Nasdaq or NYSE. In many cases, companies will decide to have their stock traded here as a way to advance to the larger markets later.

2. The company has been delisted from a major exchange. Sometimes, companies cannot meet the filing requirements, run into financial trouble, or are near bankruptcy.

3. The company has decided that it is not worth the time, effort and expense to join a major exchange. One of the most familiar examples is Nestle. While it is listed overseas, Nestle has decided that it is not worth the expense to join an exchange like the NYSE.

As you can see from the last example, not being listed on a major exchange does not mean that a company traded OTC is any less worthy of your consideration. Several very large companies, including JDS Uniphase are considered “penny stocks”, but almost no one would call them small or fly-by-night.

These smaller stocks tend to be more volatile than their bigger brothers. As they are smaller companies, the growth rates tend to be higher, and the stocks themselves tend to move at a faster pace. In fact, for many years now, smaller stocks have out gained the larger companies in performance.

To take advantage of good companies in this arena, you will need information. As these stocks are not usually followed by more than a few research firms, and may not have the finances to hire an investor relations firm, information is key to finding these stocks before everyone else does.

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