When it
comes to penny stocks, a lot of investors still have a lot of questions about
it. How was it created? Why do some do it? What are the risks? This article
will give you a breakdown of what penny stocks are. We’ll also give you a short
trip down memory lane, as well as warnings about the risks you may encounter
along the way.
Want to learn more about risky investments with high returns? Check out 4 High-RiskInvestments That Can Offer Big Returns
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| Be familiar with Penny Stocks before trading with them. |
The Birth
of Penny Stocks: How Are They Made?
Penny stocks are made through
initial public offerings, like many other traded stocks.
First, the company
needs to file a registration statement with the Securities and Exchange
Commission. Additionally, it must check state securities laws in the locations
where it plans to sell its stocks.
Then, when
the registration has been approved, the company may start soliciting orders
from various investors.
Lastly, the
company can try to have the stock listed on an exchange. An alternative option:
they can trade the stock on the over-the-counter, or OTC, market.
Small companies
and start ups usually stock to raise capital for the business’s growth. The
process is lengthy and sprinkled with tons of paperwork, not to mention
expensive. However, issuing stock is one of the most efficient ways to get
necessary capital. Penny stocks are often the result of these ventures.
Once the company
collected stock orders and sold them to investors, a registered offering can
begin trading in the secondary market via listing on an exchange. Examples of
such exchanges are NYSE or Nasfdaq. As mentioned, they can also trade OTC.
Most penny
stocks find themselves in OTC markets due to strict requirements for listing on
the bigger exchanges.
The SEC’s
Rules for Penny Stocks
Because of
some reasons, penny stocks are considered highly speculative investments. And
because of this, the SEC and the Financial Industry Regulatory Authority have
imposed specific rules to regulate penny stocks sales.
Sales
Practice Requirements
Before executing
any transaction, the broker-dealer must approve the investor’s transaction. The
customer, meanwhile, must provide a written agreement to the broker-dealer for
the same transaction. “Approving” means that you check your suitability for
such investments. This is to prevent manipulative and fraudulent practices.
Disclosure
Document
The broker-dealer
should give a standardized disclosure document to you. This document must
explain the risk factor associated in your investment, as well as the concept
related to the market, customer rights, the broker-dealers duties, and remedies
that it could take in case of fraud.
Bid-Offer
Quotations Disclosure
The broker-dealer
is required to disclose and confirm the current prices of the quotations and
related information to you prior to any transaction. If the broker-dealer fails
to follow this, it will be tagged as unlawful. This is done for you to keep
tabs on the price movement in the marketplace.
Compensation
Disclosure
This one’s
for you to become aware of the money that the broker-dealer earns from the
transactions. It will help you judge if your broker-dealer has hidden motives
in trying to affect a certain transaction.
Monthly
Accounts Settlement
The broker-dealer
is also required to send to you a monthly account statement. This statement will
tell you various details, including the number and identity of each penny stock
in your account. The statement will also explain the limited market for the
securities and the nature of an estimated price.
Eager to trade with penny stocks? Check DayTrading With Penny Stocks
What Are
The Risks?
Of course, you cannot invest in something that's risky. Risk management requires you to consider the possible downsides of your investments. It will also help you protect yourself from unnecessary risks, especially if you're not sure how much risk you can tolerate. Now, here
are the risks you should consider before jumping in to investing in penny
stocks.
Lack of
Information Available
If you want
to make educated decisions, it is important that you acquire plenty of tangible
information. Information is much more difficult to find in micro-cap stocks.
Those companies that are listed on the pink sheets are not required to file with
the SEC. This means that they are publicly scrutinized or regulated. Further,
the information that you get about micro-cap stocks is not usually from credible
sources.
No
Minimum Standards
Stocks listed
on the OTCBB and pink sheets don’t have to fulfill predetermined minimum
standard requirements just to stay on the exchange. In major exchanges, once
the company cannot maintain its position and meet the standards, the company
will have to move to one of these smaller exchanges. Pink sheets have no
requirements like this. Of course, you know that minimum standards serve as a safety
net for some investors, as well as benchmark for some companies.
Lack of
History
A huge
number of micro-cap companies are either new or nearing bankruptcy. These companies
usually have poor or non-stellar track records.
This serves as a predicament if you want to determine that stock’s
potential.
Liquidity
When the
stock doesn’t have much liquidity, you get yourself into two problems. First,
you may not be able to sell the stock. Low liquidity means more difficulty in
finding a buyer for a stock. Thus, you may be forced to lower your price until
you find an investor who wants to buy it. Second, low liquidity means more opportunities
for some traders to manipulate stock prices. This can be done in various ways.
For further reading, see also: PickingStocks: 4 Things to Consider
Bottom
Line
Penny
stocks aren’t as stable as other types of stocks, but they do have certain
advantages if you know which one has the potential to become more than a penny
stock. Once it becomes a regular stock, you can have a good payday. However,
you must understand that not all penny stocks have such potential. Therefore,
you must be very familiar with how that certain stock works.
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