Should Investors Trade in Penny Stocks?

Penny stocks are defined by no less an authority as the Securities Exchange Commission (“SEC”) as stocks issued by companies with low market capitalization, typically under $500 million. Penny stocks may trade at prices of more than $1 per share, but the SEC uses the share price to categorize them rather than their level of market capitalization. Although penny stocks are sometimes traded on major stock exchanges like the New York Stock Exchange (“NYSE”), they are notorious for their roles as vehicles for speculative ventures, even outright securities fraud, when traded on over the counter bulletin boards such as OTCBB or Pink Sheets. Because the term “Penny Stock” has taken on a somewhat derisive tone, they may also be referred to as “micro-cap”, “nano-cap” or “small-cap” stocks.

Penny stocks attract the attention of a more dubious segment of the equities investing community because the issuing companies are small and do not release news very often, leading to occasional bursts of trading activity when some news is released. The combination of infrequent information and thin trading volumes can result in a penny stock fluctuating wildly in price, and this may tempt unscrupulous traders to become involved in manipulating the stock to their own advantage.

In today’s fast-paced, electronic trading environment, spam emails often serve as the vehicle for so-called “pump & dump” scams, which work like this: a trader or group of traders sends out a series of spam emails touting a certain penny stock, perhaps accompanied by a press release with wildly inflated claims and overly rosy predictions for the stock. Because the trading volumes of these stocks are so light, even a tiny percentage of people who respond to these emails and buy the stock will cause it to rise. When this happens, unscrupulous insiders sell their shares, cease the spamming, and the stock subsequently deflates to its previous price point.

Fraudulent trading scams revolving around penny stocks are not new, in fact they have been around as long as stocks and stock markets have existed. Unfortunately, this type of activity has tarnished penny stock trading as a whole because the vast majority of penny stocks are simply low-priced shares of small companies. As the old adage goes, “caveat emptor” - let the buyer beware when buying stocks less that $5.00 per share!

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