Learning the Basics of Penny Stocks

Penny stocks are stocks that are either low in value or low in the total market capitalization. The definition of penny stocks can vary a bit from one person to another. Generally, penny stocks can be understood to mean any stock that is not a major stock. The two criteria that we have set above will determine whether a stock is a penny or not based on its price and market capitalization.

In addition, one can also consider a stock as a penny stock if it does not conform to stock exchange regulations and are thus more risky. In practice, however, it would be extremely difficult to find a large market stock that is not meeting the major stock exchange regulations. Because of this reason, penny stocks are generally understood to be those stocks whose absolute price or market capitalization is very low.

The next question that arises is ‘how low is low’? Obviously this is a little subjective and also prone to change from time to time. While there are no hard and fast rules, we can follow some rules of thumb. However, you must remember that not only are these rules not sacrosanct but also are likely to keep changing over time. Having said that, we can set some rules of thumb for considering a stock as penny stock. Any stock that is below a certain cut off price is considered as penny stock.

The cut off price is a matter of opinion. Some consider any stock below $5 to be a penny stock, while others are more liberal and consider only those stocks that are below $3 to be penny stocks. There are still others who would rather set the limit at $1, considering any stock above $1 as not a penny stock. Similarly, in the case of market capitalization, various limits are set by various people. In general, we can consider any stock with a market capitalization below $300 million to be a penny stock.

There could further classifications within this group, with stocks having a market cap of below $50 million being considered a step below penny stocks and classified as nano-cap stocks. The general idea is that any stock having a low per stock price or low market capitalization would be considered as a penny stock.

In case you are wondering what is market capitalization, here’s some information that would help you. Market capitalization (or market cap for short) is the total value of all outstanding stocks at the current price. Suppose a stock sells at $10 and there are 100,000 stocks outstanding, the total market cap would be 10 x 100,000 or $1 million. Market cap is an important indicator, because the greater the total amount outstanding the greater the stakes.

If a large number of people or a large amount of money is involved in a stock, the chances are that there will be greater control on the stock. There is one exception to this. If the stock is not traded on a regular stock exchange like NASDAQ, it is not under any regulatory control to comply with a number of regulations that have been designed to safeguard the interest of the investor.

In these cases, even if t he market cap or the price is large, there may not be sufficient safety. In general, however, we can assume that for large market cap stocks the possibility of being outside the purview of a recognized stock exchange are very remote. The reasons for this, as well as the reason why penny stocks are considered risky will form the subject matter of our next article.

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Penny Stocks Risks

The first point to remember is that large market cap stocks are likely to be registered on a national stock exchange such as NASDAQ. The reason for this is that when large volumes and amount are involved, which by definition is true for a large market cap stock, it is extremely difficult to get all that trade done outside a stock exchange. Although it is theoretically possible for a large stock to be traded on Pink Sheets and OTCBB, it will be difficult to sustain high volumes on these, because many people, who trade on recognized stock exchanges, may not trade in these stocks, particularly in large volumes.

Registration with a stock exchange involves a number of formalities that have to be complied with. These formalities are aimed at making the whole process more transparent so that the investor has access to relevant information. The availability of information helps you to verify the facts and also to check out on the soundness of the company more thoroughly. When these are missing you are operating under insufficient information and therefore are exposed to higher risk. Thus stock exchange registration by itself reduces the risk involved in investment.

Apart from this, there are other reasons why a penny stock is more risky than large market cap stocks.

Stocks registered with a recognized stock exchange are required to maintain minimum standards. These include requirements such as

Minimum number of publicly traded shares – this should be 1.1 million shares in the case of NASDAQ. The publicly held shares should also be a minimum of 10% of the total shares of the company.
Minimum Shareholder Equity
Minimum Operating income
Availability of market makers
The specified minimum amount should be available in assets, total revenue and listed securities.

There are many such requirements that a company has to meet in order to stay registered with the stock exchange. Basically, these requirements ensure that the stocks are widely held, and the company is running properly. These safeguards make the listed stocks less risky than unlisted ones, which do not have to follow any such requirements.

Penny stocks also generally do not have a history behind them, and suffer from low liquidity position. They have less room to maneuver. Because they are more risky and less preferred they will also have difficulty in raising money for new ventures or expansion. In some cases they may have difficulty in raising money even for operations. Companies generally raise money by borrowing or raising new capital. The amount that can be borrowed is limited for a given equity base. Suppose the company has $100,000 in capital, lenders may be willing to lend $200,000 or some such amount. If the company wants to borrow more money, it will have to first increase its capital base. This is more difficult in the case of penny stocks.

Finally, it might not be equally easy to find buyers in the case of penny stocks particularly if you have a large number of them. This will affect your own liquidity in the short term and also make it difficult to offload these stocks if the going is not too good.

These are some of the reasons why a penny stock is considered more risky. However, penny stocks have their brighter side too. They can give you much higher returns. We’ll see how this is possible in the next article.

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