The U.S. Securities and Exchange Commission (SEC) offers a penny profit definition for penny stocks as "low-priced shares of small companies," usually considered to be stocks that sell for between $1 and $5 apiece. Also known as "microcap stock," these stocks typically belong to companies with under $300 million market capitalizations. When such stocks rise, the penny profit per share is quite low. On the other hand, penny stocks are more affordable for small investors and can provide a way into stock trading at a low level, even though penny stocks rarely break out to produce large profits.
Buying and Selling Penny Stock
Investors typically buy stocks from broker-dealers in one of two types of transactions. In the first type, broker-dealers act as agents to the transaction, and they make money by charging a commission on the transaction. In the second type of transaction, the broker-dealer is a principal in the trade, meaning that they are the entity actually buying or selling the stock.
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Principal transactions account for a greater percentage of penny stock sales than is the case for larger stocks. As such, the broker-dealer has a financial interest in seeing the cost of shares increase, and investors should be aware of potential conflicts of interest.
The writers for Indiana University offer advice for potential investors in penny stocks to buy and sell wisely. A good guideline for when to sell penny stock is to abide by a 5:1 ratio. In other words, sell the stock if it drops more than 20 percent of the price you paid for it, or if it rises above 100 percent of the price you paid for it. If a penny stock for which you paid $3 per share rises 100 percent to $6 per share, that's a good time to go ahead and sell.
Penny Stock Calculator for Risk
Given that the penny profit, by definition, will typically not rise above double digits per share of any microcap stock, is it worth it to invest in this market? The answer, as so often in answer to questions about the stock market, is "it depends."
As the FBI noted in a story about penny stock fraud, it can be hard to find reliable available information about penny stocks and the companies that issue them. Because the SEC does not require them to file detailed financial reports, they are less transparent than larger companies. Their stock is not traded on state and national exchanges like the NASDAQ or the NYSE, but rather is sold through the OTC (over the counter) market, where there is less publicly available information about the prices of shares.
Precautions and Research
Due to the limited transparency and regulation of penny stock, it's a market that's ripe for abuse and fraud. The most common type of fraud is the "pump and dump scheme," whereby a few individuals will buy up penny stock in order to drive up its price, then encourage other investors to buy that same stock. This drives up the stock price even more, at which point the fraudulent individuals sell their stock, and the innocent investors are left holding stock that quickly becomes worthless.
However, investors can still make money and gain trading experience buying and selling penny stocks. It's wise to do plenty of research before making any investment, but penny stocks are particularly risky due to the volatility of the market. Do as much research as possible into the companies before investing, and be prepared for the vast majority of penny stock investments (as much as 90 percent) to underperform.
Consider also: Best Penny Stock Picks