Penny stocks are becoming more and more popular. Penny stocks are those that normally trade outside of the major market exchanges at a relatively low price and have a small market capitalization. In general, these stocks are treated to be highly risky and speculative.
And they are risky due to different factors that include lack of liquidity, large bid-ask spreads, small capitalization, and limited following and disclosure.
Here are some of the most important reasons why penny stocks are considered highly risky.
Lack of Publicly Accessible Information
If you have been trading for some time, you’d know that having access to a lot of key information about the company is very crucial to coming up with wise and profitable decisions in the market. However, for micro-cap stocks, information can be much more difficult to find.
Companies that are listed on the pink sheets are not required to file with the Securities and Exchange Commission (SEC). Therefore, they are not as publicly scrutinized or regulated as those stocks that are listed on the New York Stock Exchange and the Nasdaq.
And even if you find some information available, they’re not usually very credible.
No Minimum Standards
The penny stocks that are listed on the OTCBB and pink sheets are not required to fulfill minimum standard requirements to stay on the exchange. Sometimes, this is the reason why the stock exist on one of the exchanges.
For comparison, in major exchanges, once a company fails to meet minimum requirements, it can no longer maintain its position on that exchange. If the company cannot stay on the major exchange anymore, its stock will move into one of the exchanges for penny stocks. Minimum requirements serve as a safety cushion for some investors and as a benchmark for a number of companies.
Many companies that are considered to be micro-cap stocks may be newly formed or nearing bankruptcy. Therefore, such companies tend to have poor track records or even zero traceable record at all. This scarcity in stock history makes it difficult to assess its potential.
Liquidity is very important for a stock. If there isn’t enough liquidity, you might not be able to sell the stock. In addition, it might not be easy to find a buyer for the stock, meaning you’d have to lower your price until it is deemed attractive by another buyer.
Another problem that may arise out of low liquidity is that it provides opportunities for some traders to manipulate stock prices, which unfortunately can be done in a number of ways. The easiest one would be to buy a large amount of stock and hype it up, and then sell it after other investors find the stock finally attractive. This process is also called the pump and dump strategy.
As indicated in the previous section, there might be price manipulators using penny stocks. Fraud can also be very much of a problem with penny stocks. There is also no fool-proof way to guard yourself against possible fraud.