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Penny stocks, the name sounds enticing, doesn't it? Small investment in hopes of a big return. But the truth is, the high volatility and low liquidity of penny stocks makes investing in them high risk. So, before you even think of putting a penny into penny stocks, read this article to help you understand what you’re getting into.
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What are Penny Stocks?
Penny stocks are shares of small companies that trade for less than $5 a share. In the past, "penny stocks" referred to shares that traded for pennies on the dollar. In 1934, the Securities Exchange Act disclosed that securities like penny stocks, which trade for less than $5 per share, could not be listed on any index or national stock exchange.
How are Penny Stocks traded?
There are four ways penny stocks are traded:
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OTC (over the counter) directly between brokers. The OTC Markets Group operates an electronic Bulletin Board to buy and sell penny stocks. This is the most common way penny stocks are traded.
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Through Pink Sheets – a private company created to help facilitate trading of OTC equities.
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By some small brokerage firms who support penny stocks listed on OTC markets
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On major exchanges like the NASDAQ and NYSE who only trade penny stocks that meet certain standards.
Penny stock rules and restrictions
To be eligible to be listed on major exchanges like the NASDAQ and NYSE, companies offering penny stocks are required to maintain a minimum asset base and to keep their stock prices above $4. Penny stocks unable to meet these minimums will be delisted from the major exchanges and end up only being available to be traded OTC instead.
In Canada, stocks traded only on OTC markets are ineligible for inclusion in registered investment plans, like TFSAs and RRSPs. While you may be allowed to hold penny stocks traded on major markets within your TFSA, doing so may result in your account being flagged, and even audited, by the CRA(Canada Revenue Agency).
Why are Penny Stocks considered risky?
The penny stock market is mostly composed of speculative, low-priced securities. Even penny stocks listed on major exchanges can be highly volatile.
Penny stocks tend to be:
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Less liquid since they are traded less frequently
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Susceptible to higher price swings
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Offered by highly speculative, unproven companies
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Less regulated than other securities
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Harder to evaluate, since the information on them is often limited and less credible
Considering penny stocks?
As the saying goes, “If something seems too good to be true, it probably is”. The same can be true for penny stocks. So, if you're deciding to invest in penny stocks, research companies so you can evaluate whether they actually offer good investment potential. Also consider the fact that there are many other traditional stocks and securities available, without investing a lot of money. If you would like to learn more about stock market investing, check out 'how to buy stocks'.
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