Originally the term “Penny stock” referred to common shares of small public companies that trade for less than one dollar per share. However, the SEC uses the term “Penny stock” to refer to security, issued by small public companies that trade at less than $5 per share. Penny stocks are priced over-the-counter, rather than on the trading floor.
Most penny stocks trade on the OTC Bulletin Board or OTC Link LLC (which is owned by OTC Markets Group, Inc., formerly known as Pink OTC Markets Inc.). Penny stocks can also trade on securities exchanges, including foreign securities exchanges. Penny stocks can include the securities of certain private companies with no active trading market.
When considering penny stocks, investors and experts in the field recognize the low market price of shares and its correlation to low market capitalization. Market capitalization or “market cap” is the total dollar market value of all of a company’s outstanding securities.
Since penny stocks are inexpensive, investors often buy large quantities of shares without spending much money. This tendency makes the penny stock market volatile.
The volatile nature of penny stocks also leaves these companies open to potential “manipulation” by stock promoters and pump and dump schemes. Oftentimes, investors are led to believe that the ability to purchase large quantities of shares at low prices will result in greater returns, which makes them more susceptible.
The penny stock market is very illiquid. This means that holders of shares in penny stock companies often find it difficult to cash out of positions. However, academic research shows that the risk created by small market cap size and lower liquidity results in higher expected returns due to the Size and Liquidity Premium.
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In the United States, regulators have defined a penny stock as a security that meets a number of specific standards. The criteria include price, market capitalization, and minimum shareholder equity. Securities traded on a national stock exchange, regardless of price, are exempt from regulatory designation as a penny stock, since it is thought that exchange-traded securities are less vulnerable to manipulation.