The Securities and Exchange Commission (SEC) describes a “penny stock” as a security issued by a small business that trades less than $5 per share. These are usually quoted over-the-counter stocks. For example on the OTC Bulletin Board or OTC Connection (formerly known as “pink sheets”).
The stock of pennies is highly speculative. The chances of losing the entire investment in a pennies portfolio are much greater than those of hitting a home run and raking in big profits. Yet, millions of people still trade penny stocks on a regular basis. Here are 10 types of penny stock investors, whether they’re on the long side, the short side, or both.
- Experienced Penny Stock traders: Those who excel in the competitive trading world do so by carving a niche in a particular sector or commodity. Penny stocks are such a market, although the number of traders dealing in such stocks is a fraction of those dealing in shares and in blue-chip stocks. Experienced penny traders are not deterred by the restricted liquidity of the industry, its large range of bids, and its regular market price manipulation. There is nothing left for these players to impress them, particularly in such a competitive market as the Penny Stocks. They may be day traders or swing traders and take both long and short positions. (See also Pros & Cons of Day Trading vs. Swing Trading.)
- Corporate insiders. When corporate insiders, such as the top management, purchase shares of their company’s stock, they are generally seen as a sign of trust in the company’s prospects. Conversely, when these insiders sell shares, it is always a sign that the company is failing and that its stock price can crash. This rule of thumb does not extend to pennies. However, as insider behavior normally goes in one direction, the volume of sales typically dwarfs sales rates. In part because the company might be facing bankruptcies. These insiders also help orchestrate manipulations on the pennies stock market, with traders artificially pushing up demand in a single stock or group of stocks through acts such as “pump and dump” schemes. (See also: How is Pump and Dump Scam working?)
- Hedge Funds: Although certain financial institutions are forbidden from trading Penny Stocks, poorly regulated hedge funds do not have such limitations. That said, most hedge funds would not trade penny stocks on the long side: they prefer short-selling penny stocks that seem to have peaked after being heavily marketed. Penny stocks, while sometimes trade for pennies, can still be extremely risky to short because of the possibility of short-pressure. So, while the risk-reward return for shortening a penny’s stock is too distorted (i.e. providing a small reward if the short strategy works and infinite risk if it doesn’t) to be worthwhile for the average investor, the strategy may entice a deep-pocket hedge fund.
- Short sellers: Astute traders know that there is more to be achieved by short-selling pennies than by purchasing and keeping them. Unlike hedge funds, however, these traders can lack the resources required to endure the occasional short-term tightening. They must therefore rely on networking and exploit their expertise and market knowledge to recognize acceptable short-term targets whose shares would fall dramatically from current levels. These short-selling traders are unlikely to be “contrarian” and short-selling stocks that are that due to intense promotional activity. Rather, they can pile up on short positions as soon as the stock begins to sink, hoping to hasten its demise.
- Newsletter authors: Certain investment newsletter authors will generate gleaming stories on such penny stocks, for which the promoters will reward them with cash and a portion of the stock in question. Although their stock payment could be delayed for a number of weeks or months to prevent newsletter writers from dumping it immediately, they are likely to “sell to power” until their lock-up period expires.
- Investor Relations Firms: Investor Relations Companies also offer services to Penny Stock Businesses, such as coordinating meetings with investors and analysts, tailoring corporate presentations, and disseminating press releases. In exchange, they are also paid by cash and shares in the company’s stock. Unsurprisingly, these companies are likely to seek pennies rather than customers.
- Market makers: a market maker is a broker-dealer who facilitates individual security trading by showing bids and asking for quotes for a number of shares. Market makers who aim to bring liquidity to the Penny Stock Market inevitably become major contributors to trading volumes. Upon receipt of a purchase order from a trader, the market maker may either sell shares from its inventory or purchase them from the market for sale to the investor. Conversely, for a selling order, the market maker can either absorb the shares in its inventory or immediately sell them.
- Speculators: trading is the lifeblood of a penny’s stock market. But before any big sale can begin, a lot of sales have to be made to inflate the price of a penny’s stock. And much of this investment comes from long-term speculators who are well-versed in the market and have benefited from the success of the Penny Stock Trades in the past. These players continue to trade in hopes of repeating earlier achievements, but there is typically a limit: those who suffer heavy losses are likely to avoid trading a penny stock after a long time.
- Ordinary investors: Even seasoned “traditional” investors will sometimes succumb to the temptation of making a fast buck from the supposedly hot tip of a penny’s stock. It’s cold to be a friend or acquaintance who professes to be on the inside track with the Penny Stock promoters, or an investor may be persuaded by a professional newsletter writer who has built a strong investment angle. These investors may dabble once or twice on the Penny Stock Market, but once they have experienced some losses, they are likely to call it a day and stick to trading what they know best: blue chips and senior securities.
- Inexperienced and unwary investors: then there are neophyte investors who think they can make it rich in pennies. They’re caught up in the thought of buying 10,000 shares of a 10-cent stock for just $1,000, and if this 10-cent stock reaches only 15 cents, they’re going to make a cool 50-percent return on their investment. The hard truth, however, is that such a price change is very rare. Even if this occurs, large spreads of bid-ask and minimal trading liquidity also prevent investors from making fast transactions in order to close their positions and maximize their profits.
The Bottom Line
A lot of people exchange penny stocks on a regular basis but note that the amount of pennies of stock sellers dwarfs that of buyers and that only the successful ones survive for a long time in the market. If you are tempted to try your luck in penny stocks, you should regard your investment as a very short-term transaction rather than some kind of long-term strategy.