A penny stock is a securities issued by a tiny firm that trades for less than $5 per share. These are equities that are often quoted over-the-counter, such as on the OTC Bulletin Board or the pink sheets.
A penny stock has a more detailed legal meaning. A penny stock is defined as any investment that is not a National Market System (NMS) stock, is not listed on a national securities exchange, and has a bid price of at least $4 per share. Other standards must also be completed for a stock to not be classified as a penny stock. For example, shareholder ownership must be at least $5 million, net income must be at least $750,000, and the company’s market capitalization must have been more than $50 million for at least one year, among other conditions.
Before you make your first deal, the Securities and Exchange Commission (SEC) requires brokers to furnish you with a statement alerting you of the hazards associated with penny stocks.
Penny stocks are very volatile. The chances of losing your whole investment in a penny stock are significantly larger than hitting a home run and profiting handsomely. Millions of individuals still trade penny stocks on a regular basis. Here are ten different sorts of penny stock investors, whether they are long, short, or both.
1. Experienced Penny Stock Traders
Many people who prosper in the fast-paced world of trading do so by specializing on a particular area or asset. Penny stocks are one such niche, however the number of traders trading these stocks is a small fraction of those trading established securities and blue-chip companies. The sector’s minimal liquidity, large bid-ask spreads, and regular market price manipulation do not dissuade experienced penny stock traders. Even in such a turbulent industry as penny stocks, there is nothing left to surprise these participants. They may trade day or swing, and they will take both long and short positions.
2. Corporate Insiders
When business insiders, such as senior management, purchase stock in their firm, it is frequently seen as a vote of confidence in the company’s future. When these insiders sell their shares, it is generally an indicator that the firm is in trouble and that its stock price will fall. This rule of thumb does not entirely apply to penny stocks, since insider activity often goes in one direction: the quantity of selling normally outnumbers the amount of purchasing (in part because the company may be approaching bankruptcy).These insiders often assist in the orchestration of penny stock market manipulations, such as traders intentionally driving up volume in a certain company or group of stocks using “pump and dump” schemes.
3. Hedge Funds
While many financial institutions are forbidden from trading penny stocks, hedge funds are not subject to such prohibitions. However, most hedge funds will not trade penny stocks on the long side, preferring to short-sell penny companies that seem to have peaked after being extensively pushed. Penny stocks, despite the fact that they often trade for pennies, may be very risky to short due to the potential of a short squeeze. While the risk-return ratio for shorting a penny stock is overly skewed (i.e., delivering a small profit if the short strategy succeeds but limitless risk if it doesn’t), the technique may tempt a deep-pocketed hedge fund.
4. Short Sellers
Astute traders understand that shorting penny stocks is more profitable than purchasing and keeping them. These traders, unlike hedge funds, may lack the cash required to survive the rare short squeeze. As a result, they must depend on networking and leveraging their knowledge and market information to discover appropriate short targets whose shares will fall dramatically from present levels. These short-selling traders are unlikely to be “contrarian” and short-sell a rising stock as a result of extensive promotional activities. Instead, they may pile on short bets as the stock starts to fall, aiming to prolong its downfall.
5. Newsletter Writers
Some investing newsletter writers will write glowing reviews on particular penny companies in exchange for cash and a stake in the company. While their stock payout may be escrowed for a number of weeks or months to prevent newsletter writers from selling it immediately away, once their lock-up period ends, they are likely to “sell into strength.”
6. Investor Relations Firms
Investor relations firms often assist penny stock businesses by organizing meetings for management with investors and analysts, customizing company presentations, and issuing press releases. In exchange, they are often awarded with cash and stock in the firm. Unsurprisingly, these businesses are more likely to be sellers than purchasers of penny stocks.
7. Market Makers
A market maker is a broker-dealer who facilitates trading in a particular securities by posting bid and ask prices for a number of shares. Market makers that strive to offer liquidity to the penny stock market inevitably contribute significantly to trade volume. When a market maker receives a purchase order from a trader, it may either sell shares from its inventory or buy them from the market to sell to the investor. In the case of a sell order, the market maker has the option of either absorbing the shares into its inventory or immediately dumping them into the market.
The penny stock market thrives on speculation. However, before any significant selling can occur, a significant amount of purchasing must occur in order to inflate the price of a penny stock. Long-term speculators who are well-versed in the game and have benefitted from successful penny stock deals in the past are driving most of the purchasing. These players continue to speculate in the goal of duplicating previous wins, but there is typically a limit: Those who suffer significant losses will likely cease trading penny stocks after a while.
9. Ordinary Investors
Even seasoned “conventional” investors may sometimes fall to the allure of earning a fast profit on a seemingly hot penny stock tip. It may be a buddy or acquaintance who claims to have inside information from the penny stock’s promoters, or it could be a competent newsletter writer who has constructed a solid-sounding investing perspective. These investors may dabble in the penny stock market once or twice, but after suffering some losses, they’re more likely to call it quits and stick to what they know best: blue chips and senior securities.
10. Inexperienced and Unwary Investors
Then there are inexperienced individuals who feel they can make a fortune in penny stocks. They’re enthralled by the prospect of purchasing 10,000 shares of a 10-cent stock for $1,000 and profiting 50% on their investment when it drops to 15 cents. The harsh fact is that such a price shift is very rare. Even if it does occur, high bid-ask spreads and insufficient trading liquidity often hinder the investor from closing their position and locking in winnings.
The Bottom Line
Many individuals trade penny stocks on a regular basis, but keep in mind that the number of penny stock sellers much outnumbers the number of buyers, and that only the most experienced survive in the industry. If you do succumb to the lure of penny stocks, you should approach your investment as a very short-term transaction rather than a long-term plan.
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