A penny stock is any stock that trades for less than $5 a share. Generally, these stocks trade off the major exchanges in marketplaces that specialize in small company investments.
The major marketplaces for penny stocks are the electronic OTC Bulletin Board (OTCBB) and the private exchange known as the Pink Sheets.
Some stocks under $5 do trade on large exchanges, such as the NYSE, but it’s uncommon. It is common, however, to find websites that tout penny stocks as get-rich-quick opportunities.
Because penny stocks often trade for less than $1 (literally pennies), a change in share price can turn out to be a big percentage difference.
For instance, if you buy a penny stock for 75 cents a share and the price moves to $2, you’ve made 167% on your money. (Or, of course, a similarly staggering loss.)
In addition to big price swings, it’s easy to buy a lot of shares will relatively little cash. Big company stocks on indices such as the S&P 500 can cost hundreds of dollars a share in comparison.
The low entry cost and the lure of easy money brings in speculators who tend to buy and sell their shares rapidly.
Nevertheless, there are not nearly enough buyers and sellers, making small company stocks mostly illiquid.
A lack of liquidity means there can be huge price swings in a stock’s value even while try to you buy or sell shares. A market order that you expect to get filled at $2 might get filled at $3 or $4 instead.
That can result in an investor buying a penny stock position and then finding that no one else wants to buy that holding at the higher price.
While small company issues can be an important source of financing, most penny stock firms are so small that their ability to rise into the ranks of larger stocks is limited — and might not even be their business plan.
Very small companies thus report infrequently and sometimes do little to generate investor interest. What’s left is pure speculation: Can you find a buyer willing to take the shares off your hands?
Given the information vacuum, what often happens is that investors are left to talk among themselves about the prospects of a given stock they own or want to own.
An echo chamber of sentiment — both positive and negative — takes over.
The increase in discussion online gets confused for an increase in real data about the company and leads to even more speculation and volatility.
Inevitably, if one investor exits with a gain another is left with a stock that has nowhere to go but down.
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