What is the Definition of Penny Stocks

Most people have heard of penny stocks and have an idea what they are but if you were to ask ten different people, you are likely to get ten different answers.  The reason for this is that there are actually many different definitions.

To the market analyst, penny stocks are the stocks of companies that have a market cap under $1 billion and are often referred to as ‘small-cap’ stocks. If the trading price goes low enough they can even be referred to as ‘micro-cap’ or ‘nano-cap’ stocks. Originally phrased as penny stocks due to the fact that they can have prices measured in pennies (less than $1) these stocks can be over $1 and still be referred to as penny stocks. It is interesting to note, however, that to some the market cap amount used to define penny stocks is under $15 million, thus even among analysts there isn’t a clear cut definition.

If you really want to see a long rather in-depth yet confusing definition, look to the Securities Lawyer’s  Deskbook for the Rule 3a51-1 definition of penny stock.

For simpler definitions, however, you can look to the general information sites online – most often you will see penny stocks defined as common stocks that are valued at less than $5 per share and traded over the counter. Other terms often associated with penny stocks are as follows:

  • Speculative
  • Highly speculative
  • High risk
  • Usually not listed on NASDAQ or other exchanges
  • Volatile
  • Highly volatile
  • Erratic or short history of earnings and revenues
  • Sells for under $5 per share
  • Sells for under $1 per share
  • Sells for under $10 per share
  • Low price stock
  • Firms with little or no real assets
  • Trades outside the major exchanges
  • Considered pejorative
  • Small companies with highly illiquid and speculative shares
  • Companies with few regulatory standards and limited listing requirements
  • Not well established companies
  • Trade infrequently and can be hard to sell
  • Firms that are failing, or in downturn
  • Called penny shares in UK
  • Shares of small newly formed companies in highly speculative ventures

Clearly, when asked “what is the definition of penny stocks?” there is no clear answer.  More importantly, the investor that considers this type of investment must concerned with the specific stock they are purchasing than whether it falls into the classification of a penny stock.  While it is easy to see that a low priced stock does not have to gain much ground in order to double or triple one’s investment, it is just as easy for those penny stocks to render a foolish person who places their entire portfolio into this vehicle to become completely penniless.

All penny stock investors dream of finding the next big win – the stock of a start-up company that starts out as a penny stock and grows in leaps and bounds.  The problem is that without a crystal ball or a time machine, it just isn’t  possible to know with any certainty how a stock will perform – penny stock or otherwise. Just as with any financial investment, you must take the time to research the company thoroughly. Determine what they are about – are they selling a product, a service, both? Are they on the cusp of a niche ready to explode? Look over their financials – if you cannot get financials, then you may want to reconsider purchasing the penny stock of this company as nondisclosure is a good indication of a problem. Review the trade volume of the stock. The higher the trade volume of the stock the more likely there will be buyers looking to obtain your shares when you are ready to sell them. Just because you bought at $1 and decide to sell at $2 thus doubling your money, doesn’t mean someone else won’t think that they can also double theirs because they speculate it will go to $4, but if it isn’t even showing any trade volume at $1 the chances are nobody thinks it will go any higher and may even become worthless. Keep in mind, however, that both price and trading volume can be manipulated by groups working to unscrupulously defraud investors to buy into a worthless penny stock. Such people are called “market makers” and they can easily make a company that is actually a complete scam look like a legitimate offering. Thus, a low volume is a red flag but a higher volume is not foolproof.

Keep in mind that it can be difficult to locate information on penny stocks because often times the company does not have much reportable history and because they are not required to issue financial statements if they are not listed on one of the major stock exchanges.  Penny stocks trade on either the OTCBB (over the counter bulletin board) or Pink Sheets. While there are some reporting requirements for the OTCBB, there are none for Pink Sheets.

There are a number of red flags that you can watch for that may indicate a scam. A few are as follows:

  • No physical address for the company or cannot be verified
  • Company website is incomplete or does not look professional
  • Officers or employees of company show up in other penny stock companies being offered
  • Vague press releases
  • Stock options being sold immediately upon receipt by employees
  • Excessive press releases – mostly about stock price instead of the business
  • Company completely changes what it is producing
  • Company changes name often
  • Inability to open communication with company
  • Signs of dilution such as price declining for no apparent reason
  • Company will not disclose current share count

It has been said that those investing in penny stocks should heed the same advice as given to a gambler – only risk that which you can afford to lose. However you choose to define “penny stock” they are still a risky investment.