Investing in penny stocks

A penny stock is a low-priced, typically less than $5, common stock, which trades in over the counter markets (OTC) and not on any of the major exchanges such as NYSE, NASDAQ or AMEX. Typically penny stocks represent share in small companies, with market capitalization under $50 million. However, they represent a great percent of the daily trading volume.

Listing requirements for penny stocks are the minimum. However, the lack of minimum accounting standards, change in notification of ownership of shares, and reporting of other material changes affecting the financial viability of a company, actually leave investors unprotected.

Penny stocks are a high risk investment. Investors consider penny stocks as a way to speculate about the market because of their low price and growth potential. Speculation is based on penny stock companies having lower available information about their operations, minimal revenues, unproven management, and often an unproven product or industry. For example, big companies such as Coca Cola have minor speculative value.

It is not possible to calculate the actual worth of most penny stocks. Some do not have inventories, a revenue stream, or even a proven product. The shares rise and fall based on buying and selling demand, and that demand is driven mainly by waves of speculation. By their nature, it is nearly impossible to know what price a penny stock share should be trading at, and conventional financial ratios and industry comparisons are rarely effective measures for realizing a penny stock’s tangible value.

Penny stocks have very limited liquidity because they have fewer shareholders and they do not trade the same amount of shares that large companies do per day. Penny stocks are also extremely volatile because the risk is not allocated among numerous portfolios like it happens in stocks with high market cap. Penny stocks often experience dramatic price swings, and often these moves are the result of a large buy or sell order. It is not unusual to see a drop of 20% or 50% during a trading and even return to their original starting point by the end of that same day. Lack of liquidity makes penny stocks difficult to sell and/or to short because the number of buyers is small. Moreover, the lack of financial reporting makes penny stocks vulnerable to manipulation, particularly those with low volumes traded over the counter.

Penny stocks do better in niche markets. Lacking the resources and capital the large companies have, as well as name recognition for their product or service, penny stock companies avoid entering a pre-existing market that is already driven by a dominant force. Typically, penny stock companies perform best in niche markets.

On the other hand, picking the right penny stocks can assist average investors, who are not extremely experienced, to realize great profits. The trick is to protect investment in a way that ensures the gains more than offset the losses.

The differences between the New York Stock Exchange and NASDAQ

The New York Stock Exchange (NYSE) is the largest stock exchange in the world with a combined capitalization of NYSE is $25.0 trillion. Over 2,700 securities are listed in NYSE, which is a physical location exchange with own building, a limited number of members and an elected governing body. Although everybody stands up, members are said to have seats on the exchange. The 1,366 seats, which are bought and sold, give the holder the right to trade on the exchange.

The New York Stock Exchange is a modified auction market, where buyers and sellers trade securities of listed companies. NYSE is open on all normal working days, from 09:30 to 16:00, with the members meeting in a large room equipped with electronic equipment that enables each member to communicate with the firm’s offices throughout the country. Special facilities are offered to institutional investors such as mutual funds and pension funds, so that they can sell large blocks of stock without depressing their prices. In fact, brokerage houses that cater to institutional investors purchase blocks of 10,000 shares of more and resell the stock to other institutions or individuals. In addition, when a firm has a special announcement that is likely to cause a major change in the stock price, the brokerage house asks the exchange to halt stock trading until the announcement is made and evaluated by investors.

The National Association of Securities Dealers Automated Quotation System (NASDAQ) is the largest stock exchange in the world in terms of daily traded volume with 3,200 listed securities. NASDAQ is a self-regulatory body that licences brokers and oversees trading practices. It is not a physical location exchange, but a computerized network, with no members and no governing body.

NASDAQ started as a quotation system, but over time it has grown to become an organized securities market with its own listing requirements and 400 market makers, who market the stock and are responsible for its liquidity. It allows multiple market participants to trade through its Electronic Communication Networks (ECNs) structure, in the pre-market trading hours (7:00 – 9:30), market-hours (9:30 – 16:00) and after hours (16:00 – 20:00).

Not all securities trade through the NASDAQ system. NASDAQ operates the Nasdaq National Market list, where the larger NASDAQ largest stocks are listed (Intel, Microsoft etc), and the Nasdaq SmallCap Market list, where small companies with high growth potential are listed. NASDAQ also operates the OTC Bulletin Board, which lists quotes for stocks registered only at the Securities Exchange Commission (SEC) and not on any exchange. Also, NASDAQ operates the Nasdaq Pink Sheets, for stocks not registered with the SEC.

In order to become more competitive with the NYSE and the international markets, NASDAQ has merged with the American Stock Exchange (AMEX) in 1998 to form an organized investment network. Although this network is still referred to as NASDAQ, securities are traded separately on the two markets.

How the New York Stock Exchange operates

The New York Stock Exchange (NYSE) is a primary listing markets where corporate stocks are primarily or formally listed. Established in 1817 under the name the New York Stock and Exchange Board, the exchanged was founded when Buttonwood Agreement was signed in 1792 by twenty four brokers. It was renamed the New York Stock Exchange in 1863.

New York Stock Exchange is the largest organized securities market in the United States. NYSE is a physical location exchange with own building, a limited number of members and an elected governing body. Although the trading happens with members standing, there 1,366 so called seats, which are bought and sold and give the holder the right to trade on the exchange. Approximately 2,750 companies have stock issues listed in NYSE, for a total of about 3,000 stock issues, both common and preferred, reaching a combined capitalization of $25.0 trillion.

The listing requirements for NYSE include a pre-tax income of $2,500,000 the last year and $2,000,000 the last two years, 1,100,000 publicly held shares with a market value of $100,000,000, while the minimum number of holders of round lots (100 shares or more) should be 2,200.

The average number of shares traded daily on the New York Stock Exchange has increased steadily and substantially. Prior to 1960, the daily traded volume averaged less than 3 million shares, while in 2006 it exceeded 1.7 billion shares. In terms of trading volume, the New York Stock Exchange has dominated all other stock exchanges in the United States, such as the National Association of Securities Dealers Automated Quotation System (NASDAQ) and the American Stock Exchange (AMEX). This is basically attributed to its stringent listing requirements and its prestige, which attract most of the largest and best known U.S. companies to be listed on NYSE.

Being a modified auction market, where buyers and sellers trade securities of listed companies, the New York Stock Exchange offers to its members a large room equipped with electronic equipment that enables each member to communicate with the firm’s offices throughout the country. Institutional investors, mutual funds and pension funds are provided with special facilities in order to facilitate the selling of large blocks of stock without depressing their prices. In fact, brokerage houses, which cater to institutional investors, purchase blocks of 10,000 shares of more and resell the security to other institutions or individuals.

NYSE is open on all normal working days, from 09:30am to 4:00pm Eastern Time. In particular the timetable for trading on the New York Stock Exchange includes the Pre-Opening session (03:30am – 4:00am), the Opening Session (04:00am – 09:30am), the Opening Auction  (04:00am – 09:28am), the Market Order Freeze Period (09:28am – 09:30am), the Core Trading Session (09:30am – 4:00pm), the Closing Auction Freeze (3:58pm – 4:00pm), the Closing Auction Run (4:00pm), the Extended Hours (4:00pm – 8:00pm) and the Limit Orders Cancelled (8:00pm).

An overview of the NASDAQ Stock Market

The National Association of Securities Dealers Automated Quotation System (NASDAQ) is an automated, electronic quotation system. NASDAQ is a self-regulatory body that licences brokers and oversees trading practices. It is not a physical location exchange, but a computerized network, with no members and no governing body.

NASDAQ is the largest stock exchange in the world in terms of daily traded volume with 3,200 listed securities. It has historically been known as over-the-counter (OTC) market, which included stocks not formally listed on New York Stock Exchange (NYSE) or American Stock Exchange (AMEX). Over time NASDAQ has grown to become an organized equity market with its own listing requirements and 400 market makers, who market the stock and are responsible for its liquidity.

NASDAQ is a dealer market, which allows multiple market participants to trade through its Electronic Communication Networks (ECNs) structure, in the pre-market trading hours (7:00 – 9:30), market-hours (9:30 – 16:00) and after hours (16:00 – 20:00).  Stocks are traded on NASDAQ as long as there are dealers who indicate a willingness to make a market by buying or selling for their own account.

The NASDAQ system makes all dealer quotes immediately. The quotation system has three levels to serve firms with different needs and interests.

Level 1 provides a single median representative quote for the stocks listed on NASDAQ. These quotes are for firms that do not consistently buy or sell stocks for their customers but they want to be aware of the current quotes on NASDAQ. Level 1 quotes change constantly to adjust for any changes by individual market makers.

Level 2 provides on-the-spot current quotations on the NASDAQ stocks by all market makers in a stock. These quotes are for firms that consistently trade NASDAQ stocks. Given a order to buy or sell, market makers put the highest bid if they sell, the lowest offer if they buy and consummate the deal.

Level 3 is for NASDAQ market makers. These firms want Level 2, but they also need the capability to change their own quotations, which is provided by Level 3.

Not all securities trade through the NASDAQ system. NASDAQ operates the Nasdaq National Market list, where the larger NASDAQ largest stocks are listed (Intel, Microsoft etc), and the Nasdaq SmallCap Market list, where small companies with high growth potential are listed. NASDAQ also operates the OTC Bulletin Board, which lists quotes for stocks registered only at the Securities Exchange Commission (SEC) and not on any exchange. Also, NASDAQ operates the Nasdaq Pink Sheets, for stocks not registered with the SEC.

For initial listing on NASDAQ stockholder’s equity should be $15 million for Level 1 and $30 million for Level 2, while for Level 3 is not required. Publicly held shares should be 1.1 million for all three levels, while their market value should be $8 million for Level 1, $18 million for Level 2 and $20 million for Level 3. Minimum bid price is $5 for all three levels and shareholders of at least 100 shares should be 400 for all three levels. Finally, 3 market makers are required for Level 1 and Level 2, and 4 for Level 3.