Blog : Official Penny Stock Definition

You've heard of penny stocks.  Most likely that was comprised of investment horror stories, but sometimes (although rarely) it may have involved tales of instant overnight wealth. Either way, you've probably picked up a few preconceived notions about penny stocks.  Well, some of your beliefs are correct.  Some are also incorrect.

 

Let's start from the very beginning (which is a weird thing to do four paragraphs in).  There is no universally-embraced definition of penny stocks.  Your stock broker may disagree with your beliefs, while a professional hedge fund manager may be at odds with the Securities and Exchange Commission (S.E.C.) on the topic. 

If you are like most people (present company included), you probably consider penny stocks to be those shares which are trading for (as the name implies) pennies.  However, the closest thing to an official definition was chosen by the ones who make the rules, the S.E.C.  They state that any stocks trading at less than $5 per share are penny stocks.

Others use total company size (market capitalization) as an indicator, such as any publicly-traded business whose total value is less than $50 million.  Since companies change in value with each change in share price, by this definition, what was a "penny stock" at 10 a.m. may be no longer labelled as such by noon, then could be back to penny stock territory by 3 p.m.  

This becomes problematic for definition purposes, but the majority of the industry still leans on the S.E.C. $5 per share version.  Regular Joe investors (that's us), are more likely to consider shares in the price range between 1 cent and a couple dollars as penny stocks.

However, for regulatory and investor protection reasons, that $5 threshold is significant.  In the world of multibillion dollar blue chip companies, like IBM, Apple, and Exxon, it is not a stretch to consider shares trading at a few dollars to be "tiny."  Those smaller companies are riskier, more volatile, and often have a financial position worthy of their share price.

The result?  Special rules are applied by the S.E.C., to make sure that investors don't "harm" themselves by investing in highly speculative shares, nor fall victim to the scams that thinly-traded stocks enable for dishonest individuals.  Stocks which trade for $4.99 will have different regulations than those worth $5.01 or more.

Since any shares trading for less than $5 are considered more speculative and risky, they are not considered to be "option eligible" by most brokers and the S.E.C.  This is just a fancy term that means you can not trade or write options on the underlying shares, and sometimes special fees and regulations govern trading in investments which are technically "penny stocks."  

This will not affect 99% of penny stock investors in any way, so don't feel bad if you purposely forget the last three paragraphs of your life.  What will affect you is that the vast majority of companies whose shares trade for less than a couple bucks are not good investments (our personal, educated opinion, based on decades in the field).

"Not good investments" may be the understatement of the century.  However, the purpose of our comments here are not to rag on low-priced investments, but rather to give you an introduction into these type of shares, and perhaps even a glimpse into what penny stocks can mean for you, if you learn how to find the great ones.

Remember, buying a share of stock is simply buying a share of a business.  If the business grows, those shares typically increase in value.  Most investors treat penny stocks like they are buying a lottery ticket - they invest, then hope that the shares balloon in value, thus bringing them everything they ever wanted in life.  However, the successful investors in low-priced shares are generally those who understand a great business when they see one, and purchase shares early when they are still available for a nickel or a few dimes.