Many penny stocks do not trade in New York Stock Exchange or in other national stock exchanges. Often, penny stocks are traded through over-the-counter bulletin boards. These OTC traded stocks are commonly referred to as pink sheets.
Trading these stocks through an online broker has become as simple as investing in stocks that are listed on the national exchanges. However, investors should recognize that OTC trading involves heightened risks. Investors who are considering OTC trading should do extensive research before trading.
What Are Penny Stocks?
Penny stocks are shares issued by small companies that trade at low prices – less than $5, according to the Securities and Exchange Commission’s definition. Like stocks with higher share prices, penny stocks can be worthwhile investments. However, sustained low share prices and low market capitalizations can disqualify penny stocks from trading on national exchanges. As a result, penny stocks often are traded through over-the-counter bulletin boards.
OTC Bulletin Board Pink Sheets
Pink sheets are stocks that do not trade in the major stock markets. Instead, they are listed on over-the-counter bulletin boards. These stocks are called pink sheets because, historically, their prices were quoted on sheets of pink paper. Today, the electronic inter-dealer market displays quotes from brokers who would place orders to sell or buy shares.
Penny Stocks Carry Higher Risk
Penny stocks are subject to greater risks than most exchange listed stocks. In particular, these stocks tend to be thinly traded and are seldom researched by analysts. These factors create liquidity risk and make trading prices more arbitrary.
Pink sheet investors may be forced to wait long periods before selling their shares, because of their infrequent trading habit. Penny stock investors must spend extra effort researching their investments because far fewer market participants and analysts have researched these stocks.
Pump and Dump Schemes
Stock promoters often exploit penny stocks by endorsing them to pump up prices and then selling or dumping their shares to capture a profit. This market manipulation can harm investors who buy at pumped prices. Thin trading and scarce research make penny stock environments particularly attractive for pump and dump activity. Investors should be aware that pump and dump is an illegal scam, which is sometimes advertised in online chat rooms and bulletin boards as well as social media platforms such as Twitter and Facebook.
Penny Stock Due Diligence
Investors should not assume that these stocks are fairly priced or that a penny stock company is still in business. Unfortunately, information on penny stock companies is usually harder to find. Asking your broker for help may provide leads for your stock research. Rule 15c2-11 of the 1934 Securities Exchange Act requires brokers to keep information about the issuing company.
Selecting a Broker
Many online stock brokers such as TD Ameritrade and E*Trade provide over-the-counter and penny stock trading. However, many brokers apply special charges for trading penny stocks or for trading outside the stock exchanges. Investors should research any extra fees that are charged for penny stock trading or over-the-counter trading before creating an account with a broker.
Joe Escalada is a financial analyst. He earned a Master of Business Administration from the University of California at Davis and has passed all three Chartered Financial Analyst examinations. He has a bachelor's degree from the California Institute of Technology.