Don't let the name fool you. "Penny stocks" is a phrase used to describe any small company that offers shares of stocks for less than five dollars. Some can certainly be as small as a penny, but those are few and far between.
Unlike other, bigger stocks, penny stocks can be quoted over the counter (OTC) and can be found on sites like OTC Link LLC. However, they can still be made available on securities exchanges, as well, which is why penny stocks may also involve securities in private companies that don't otherwise trade on the market.
Tim Sykes is perhaps the most famous penny trader, having turning his bar mitzvah money into a million bucks by the time he was 21. Penny stocks can be more challenging to sell than other stocks, and traders can get stuck with them far longer than they'd like. After all, a person needs to have a buyer in order to sell, but that's more often a given with larger stocks.
How to think about penny stocks
Penny stocks can be difficult to price accurately, because quotes are hard to come by. Given the challenges surrounding penny stocks, they're regarded as speculative investments. Penny stock traders shouldn't assume they're safe just because smaller amounts of money are often at stake.
It's entirely possible for penny traders to lose their entire investment, or at least a large chunk of it, especially for those who are new to trading. Penny stocks that are bought on margin are especially volatile and best left to skilled traders.
The nature of these stocks is what made Congress stop broker-dealers from working with penny stocks -- unless they followed strict guidelines. The Securities Exchange Act of 1934 breaks down what's legal and what's not when using a penny trader. The rules are vast, but one of the most crucial is that the customer must have a written agreement for all transactions. The broker also has to supply the customer with a disclosure agreement that clearly details the risks of penny stocks.
Breaking down the rules
In an effort to preserve transparency, the Act requires a broker to disclose fully any market quotation, if one exists, and the customer needs to know exactly how much compensation the broker and/or firm will take. The broker is also required to send monthly statements to each customer to leave a paper trail. This red tape is intended to protect customer and broker alike, since things can get ugly when money takes a downward spiral. These are some of the basics of the law.
Is it smart to use a penny broker since people can often buy stocks OTC for a low sum? The easy answer is yes, especially for traders that are new to the field. Brokers have experience, they've learned lessons the hard way, and they truly have each customer's best interest at heart, since their income is based on how well they buy stocks for other people.
Getting into penny stocks
From a customer's perspective, it's almost always a good idea to have a broker take the reins in the beginning. Find a broker who's willing to share his or her knowledge, and make sure the broker's compensation is clear. Learn from the best, and recognize that being successful takes hard work.
Becoming a broker requires that you follow the strict guidelines of the US Securities and Exchange Commission. This requires Form BD, SRO Membership, SIPC Membership, and observing any state requirements that are in place. Follow the guidelines carefully to avoid any trouble down the road, and ensure that future customers' interests are protected.
Being a broker can be an exciting and lucrative career, but it doesn't come without risks, so be forewarned.
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