Penny Stock Rules
Penny stocks are a risky but potentially lucrative option for the investor who’s willing to gamble a bit and trust his or her luck. These low-priced stocks rarely cost a penny anymore, but they can run just a few dollars per share. This is because they’re connected to relatively small, unknown companies trying to raise capital that will expand their business. Many of these businesses will fail, which is what makes penny stock trading such an exciting activity.
Major businesses such as robotics company Computer Motion and Xerox started their lives as penny stocks, so these investments can lead to major payoffs if the investor is lucky. Like any other kind of investment, however, penny stocks come with a number of rules.
These stocks are regulated by the U.S. Federal government to ensure that only particular stocks can be traded under the name “penny.” They’re also covered by a set of basic trading guidelines that smart investors will adhere to. Knowing about these basic penny stock rules can help savvy traders improve their luck when they gamble on penny stocks.
Federal Penny Stock Rules
The U.S. Securities and Exchange Commission regulates penny stocks the same way it regulates any other investment. According to the SEC, a stock can only qualify for the “penny” appellation if its price is below $5. Penny stocks must also be associated with very small companies and are usually traded over-the-counter, or outside the usual exchanges. This is often because penny stocks don’t qualify for exchange listings. These stocks are usually traded in the Pink Sheets, also called the OTC Market Group, or the OTC Bulletin Board.
Because penny stocks are hard to guarantee, they carry a few additional regulations. SEC rules require firms to approve each customer individually before he or she can purchase penny stocks from a broker-dealer. The customer must agree to the transaction in writing. After a customer submits this agreement, the broker-dealer must provide a written document that describes the risks of penny stock investment.
The firm is also responsible for telling the customer the penny stock’s current market quote, plus how much compensation the firm and the dealer will receive for the deal. Each month, the firm is required to send the customer an account statement that includes the market value of every penny stock that customer currently holds. The SEC notes that accurate pricing for penny stocks can be difficult, since these stocks aren’t always traded very frequently.
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Penny Stock Rules for Successful Investing
The SEC also publishes a series of guidelines for investors who wish to trade in microcap, or micro-capitalization, stocks, a group to which penny stocks belong. These are not legal requirements, but they are good advice for anyone who would like to get started in the exciting world of penny stocks.
- 1. Understand the risks – While penny stocks have occasionally made traders rich, the majority never significantly gain value. They can even lose value, since it is often hard to trade a stock this small. For investors who have a little money to spare, however, buying a few penny stocks provides a thrill and the chance of making it big, as long as they understand what’s at stake.
- 2. Research penny stocks carefully – Since the companies represented by penny stocks are so small, there may be very little readily available information about them. Investors who want to make a smart investment in penny stocks should be advised to research their potential stocks carefully. These stocks are rarely reviewed by professional stock analysts, which makes them more vulnerable to fraud.
- 3. Look for SEC reports – Most penny stock companies aren’t big enough to file with the SEC or list their stocks on standard exchanges, but those that do can provide significantly more information than their smaller cousins. This makes them a potentially-smarter investment. Companies that don’t register with the SEC usually meet either Reg A exemption requirements, where they raise too little money over the course of a year, or a Reg D exemption, where the company raises very little money and sells to a very small number of investors.
- 4. Watch for signs of fraud – Penny stocks are a popular target for investment fraud since there is so little information available about them. Some of the most common signs that a penny stock has been targeted by a fraud include receiving information about the stock as “spam” email or via an Internet chat room, receiving a cold call about the stock, or encountering a press release or investment newsletter that provides exaggerated or unbelievable claims. Information about penny stocks should always come from the SEC, the company itself, or a state securities regulator.
- 5. Choose only reputable brokers – Potential penny stock investors can improve their chances of a legitimate investment by researching their brokers as well as the stocks themselves. By taking the time to make sure the broker and the firm he or she belongs to have been registered with the SEC, can do business in a particular state, and have no complaints filed against them with the state securities regulator, investors can protect their money and increase the odds of finding a winner.
- 6. Avoid suspicious companies – Traders who know the signs of a bad penny stock can avoid the risk of losing money. A stock that has previously been suspended from trading by the SEC due to unreliable or inaccurate information may be a bad bet. Other potential red flags of which investors should be aware include high pressure sales methods and large asset listings combined with small revenues. Bad risks may also have unusual loans, a record of past auditing issues, or a large amount of stock in the hands of insiders.
Potential investors shouldn’t let themselves feel intimidated by the prospect of investing in penny stocks. After all, this kind of investment opportunity could lead to a winning company that becomes the next Intel. Because these stocks can be so unpredictable, however, following the SEC’s penny stock rules is a smart decision. Choosing a good penny stock could be the route to a big payoff some day in the future.
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