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Penny Stocks or Micro cap Stocks

A lesson for Investors of Penny Stocks, Small Cap
and Micro cap Stocks.

This page is designed to provide the investor or trader, with general information about small cap stocks or penny stocks and the markets in which they are traded. Because there can be illegal activity involving small cap stocks, this page tries to caution investors about penny stocks be assured that illegal activities have been seen on all exchanges including the NYSE over the years but the majority of activity has taken place on the lesser requirements exchanges. Many small, reputable, legitimate companies issue stock that trades for pennies a share in the over the counter market or OTCBB and Pink Sheets Remember Microsoft ( MSFT ) was once a penny stock. The trick is to be able to spot the potential legitimate winners and the potential losers.

What are micro cap or penny stocks?

The terms "micro cap" stock and "penny stock" have been used to describe a particular segment of the securities market. As both terms suggest, these stocks are generally low-priced securities issued by small companies. A penny stock is generally a security that is priced at less than $5 per share and is not traded on Nasdaq or listed on a stock exchange. "Micro cap" stock generally describes a low market capitalization of less than 5 million when the number of shares is multiplied by the stocks price.

Under the federal securities laws, penny stock is defined generally as: an equity security that is not listed on Nasdaq or a national securities exchange and either (a) has a price per share that is less than $5 or (b) whose issuer has net tangible assets that are less than $2 million, if the issuer has been in continuous operation for at least three years; or a market capitalization less than $5 million, if the issuer has been in continuous operation for less than three years; or whose average revenues are less than $6 million for the last three years. See Section 3(a)(51) of the Securities Exchange Act of 1934, 15 U.S.C.  78c(a)(51), and Rule 3a51-1, 17 C.F.R.  240.3a51-1.

The plain fact is that today you can find stocks that sell for less than $5.00 on all exchanges including the NYSE. You can on most days find stocks that are trading for less than a dollar or for pennies on every exchange including the NYSE, NASDAQ.

When the Commission adopted the $5 threshold for penny stocks it cited three reasons: 1) the perceived difficulty of manipulating higher valued stocks; 2) the fact that $5/share was the threshold for the ULOR/SCOR -- a uniform, streamlined state registration form for companies raising less than $1 million under the Rule 504 exception under Regulation D; and 3) the perception that legitimate small businesses could still raise capital and the liquidity for their shares would not be impaired.

The term "micro cap" is not a term defined under the federal securities laws. Lipper Analytical Services, a mutual fund rating organization, generally categorizes micro cap companies as companies with market capitalization's of less than $300 million. In general, securities of micro cap companies are quoted on Nasdaq's OTC Bulletin Board, in the National Quotation Bureau's Pink Sheets and on the Nasdaq Small Cap Market.

The "OTCBB, NYSE, NASDAQ and Pink Sheets" markets

Penny stocks are traded on all markets if you use the definition of less than $5.00 stock price.  If you purchase a low-priced security that is listed on NASDAQ or the NYSE and the OTCBB, it will meet certain minimum standards. The standards change from time to time and understanding these standards may help you make better investing decisions. The minimum requirements for being listed on the NASDAQ small cap are here. And the National market requirements for the NASDAQ are here. Although the OTCBB does not have any listing requirements per se, to be eligible for quotation on the OTCBB, issuers must remain current in their filings with the SEC. Market Makers will not be permitted to begin quotation of a Stock whose issuer does not meet this filing requirement. Stocks already quoted on the OTCBB that become delinquent in their required filings will be removed following a 30 or 60 day grace period if they do not make their required filing during that time. A fifth character of "E" in a security's trading symbol is used to show securities that the NASD believes are delinquent in their required filings; securities so denoted will be removed from the OTCBB after the applicable grace period expires. A more complete listing of the rules may be found here. The listing requirements for the NYSE can be found here.

Another component of the OTC market is the National Quotation Bureau's (NQB) service, commonly referred to as the "pink sheets." The NQB's securities lists and price information, is printed on sheets of pink paper, prices for these stocks used to be hard to obtain. You had to call brokers and they in turn would call market makers to get the prices. Today the Internet has provided for a much more available stock quote. You can find Pink Sheet quotes here. The Pink Sheets market is the Wild West of markets in the US. The market has the lowest level of requirements to be quoted of all us markets. That is to say there are no minimum quantitative standards, which must be met by an issuer for its securities to be quoted on the Pink Sheets. Additional pink sheet stock listings information is here.

Stocks can be traded on all the exchanges and not meet the requirements for a period of time. The time they are listed while not meeting requirements may very do to appeals and other circumstances. These stocks will generally move down to the next level of the markets.

Generally speaking the NYSE , NASDAQ, NASDAQSC, OTCBB, Pink Sheets is the order of priority for companies to be listed by market. The NASDAQ has become a much more desirable place to be listed and many companies who could be listed on the NYSE have decided to stay on the NASDAQ. As legitimate companies grow they will progress up this ladder of markets.

Buy and Sell or the Bid and Ask:

All stocks have two prices one for the price it can be bought at and one that it can be sold at. The bid price and the ask price. The bid price is how much someone is willing to pay for the stock, or the price at which you could sell your shares. The ask price is how much someone will sell their stock for, or how much you will have to pay. The difference between the prices is called the spread.

The Spread or Difference between the Buy and Sell:

For most investors, the spread represents a built-in loss at the time of investment. For example, if you purchased a stock that traded at $0.50 cents bid, $1.00 dollar ask, you would have paid $1.00 and the bid would have to more than double in price for you to break even (the "more than double" comes from additional costs such as "order fees" charges and other miscellaneous costs). Many investors buy penny stocks believing that "trading at 10 cents" means that they can buy and sell at 10 cents. Most of the time this is not true. The spreads in penny stocks are commonly 25-33%, are often 50-100% and sometimes even higher. There are some penny stocks that trade within very small spreads as well. Once again remember that there are exceptions to about all the general rules.

Another factor to keep in mind when evaluating price information about penny stocks is that there are two "bid" and two "ask" prices, the inside and outside bid and ask. As a general rule, the price you will be interested in will be the outside bid and ask, or the lower bid and the higher ask, as those are the bid and ask prices to public customers.


The last pricing factor concerning penny stocks is called the markup. A broker-dealer who has held the security in its account and subject to the risk of market price fluctuation, may mark the price of the security it sells to you up by a certain percentage, on top of the spread. This is to compensate broker-dealers for maintaining inventory sufficient to supply demand for an orderly and liquid market. What it means to the average investor is another cost that creates a built-in loss at the time of investment. In other words, the instant your transaction is effected, your securities are worth less than you paid for them.

Although it is no guarantee of a good price, you are more likely to get a better price in an agency transaction using a broker-dealer that has no interest in the transaction, due to the pricing factors above. In the typical penny stock transaction, the broker-dealer buys from its customers at the bid and sells at the ask, capturing as compensation the spread, plus any markup and fees.

With the invention of the Internet, online trading and the level two quotes provide a view of the top market makers in most any given stock. You can see individual orders as you enter or place them in many stocks.

Market makers

A market maker is a broker-dealer who stands ready to buy or sell shares of the stocks in which it makes a market. When a transaction is proposed, the market maker will give a price at which it would be willing to effect that transaction. The market maker's price applies only to the listed number of shares in the offer. While the market maker system has been widely criticized the system does offer investors some level of fairness. The more market makers there are in a given stock, the more likely they are to bid against each other, and the price will more likely move to a true "market" price. Market Makers have been called most every name under the sun and some folks rank them down with used car salesman and lawyers. Market Makers in the NYSE are committed to different rules than those quoting Pink Sheet Stocks. For example a NYSE stock that was Bid at $0.50 and the ASK was $0.75 you place a limit order at $0.625 the market maker is obligated to post your better bid or they may fill the order. The Pink Sheets Market Makers have no such obligation at this point. There is a great book on Market Makers you can learn from here.

Manipulation and or Pump and Dump

The manipulation and or Pump and Dump of companies stocks has grown in number recently mostly because of the Internet. The Internet has provided a vehicle for the communication of stock or company information at very low costs to large numbers of people by just about anyone. Individual investors as well as NASD firms have been arrested for various schemes involving stocks of small and even some large cap stocks. These Pumps and Dumps are done by posting of messages on bulletin boards, issuing false press releases, creating newsletters, and building web sites to hype or de-hype stocks. ( Hype = To raise the expectations for a company and its stock. The Pump and Dumper would be long the stock. ) ( De-Hype = To lessen the expectations for a company and its stock. The Pump and Dumper would be short the stock. )

Another powerful form of manipulation is the analyst reports that upgrade and downgrade stocks of companies. Most all large brokerage houses have research departments that create reports of a supposed independent nature. The independence of all reports should be suspect. The reports can be self fulfilling depending on the audience size and makeup for the report.

Stock manipulators need stock.

They usually get it in one of two ways. One way is to find a "shell" company that already has issued publicly trading securities. This shell company typically has little or no operating history; few assets; few, if any, employees; and slim prospects for financial success. The shell is sometimes merged with a privately-held company.

The other vehicle for these individuals to get stock is to take advantage of exemptions from the federal registration requirements. The securities involved are usually traded in portions of the OTC market where public information is limited and a small number of brokers control the market.

The securities are usually sold through hype or high pressure tactics, often involving "boiler room" operations where a small army of sales personnel cold call potential investors using scripts to induce them to purchase the "house stocks" -- those stocks in which the firm makes a market or has a large inventory.

The information conveyed to investors often is at best exaggerated and at worst completely fabricated. Once they have lured investors, the unscrupulous brokers employ a variety of inappropriate practices, from "bait and switch" tactics, unauthorized trading, "no net sales" policies (where investors are discouraged or actually prevented from selling their stocks) to churning (excessive trading in their accounts in order to generate commissions for the broker). The firm often charges excessive, undisclosed markups and issues arbitrary stock quotations.

The price continues to rise until there are no more investors who will buy, and then the bottom falls out and the price plummets. Sometimes the broker-dealer will buy back the securities at the fallen prices to recapture the stockpile for a future revival of the stock; more often individual investors and traders are simply left holding the over inflated stock.

This same thing can be done by a single investor or a group of investors on the Internet. They will begin buying a stock that preferably has a small float or low number of outstanding shares and is near its price lows. They buy small quantities of the stock over a period of days or even weeks so that the price does not rise or rises very little from its lows. Once the investor or investors have the shares they want they will begin sending newsletters, posting to message boards and posting to chat rooms about the company and its stock. These posts can contain real and or false information. The important thing to understand is that within minutes a group can get the information on a stock to thousands of investors over the Internet. When the information is received by the thousands of investors and traders they will in some cases buy the stock on the merits of the information others will do more research and others will just ignore or delete the information. The key to the Pump and Dumpers is to get some buyers for the stock. Many times a stock will take off like a rocket with the bid and ask heading higher as more and more orders are placed to buy the stock. The Pump and Dumper will in most cases already have their sell orders placed at some price higher than they paid and well below their posted target prices.

As example of how powerful these Internet mediums can be,  once in a chat room that focused on news for stocks. A press release was posted to the room and a wrong stock symbol was posted as if it was the company mentioned in the release. The release spoke of some kind of big order from a major company. The stock of the company whose symbol was wrongly posted in the chat room began to see buyers. The stock ran from around $2.00 to over $4.00 in about five minutes. Then someone posted to the chat room that the symbol was wrong and yep the stock price plummeted back to below $2.00 in less than a minute. There were many who made money and many more who had big loses.

Another example would be Comparator Systems Corp.

The ability to artificially inflate the price of a stock, in this instance using the Internet, was showcased in the dramatic rise and fall of the stock of Comparator Systems Corp. The Securities and Exchange Commission brought an action against Comparator and three of its officers and directors, alleging that the defendants sold tens of millions of shares of the company's stock while falsely representing that they owned certain fingerprint technology.

The company's financial statements had been falsified, allowing Comparator to remain listed on the Nasdaq Small Cap Market and avoid classification as a penny stock.

Due to touting on the Internet and Telivision, the company's stock price rose from $0.06 to $1.88 over three days, setting Nasdaq trading volume records. The stock was halted by the SEC and investors lost millions.

Now just imagine if you could tell thousands about a stock. You should be able to get enough buyers for a stock so that the price would go higher. If the news or information was good enough.

Understand that the Internet also offers the independent investor or trader the ability to have conversations both before and after they have bought a stock. These conversations between members of a chat room or message board do not always present a Pump and Dump scheme. They can and probably mostly are just shareholders or interested investors talking about the pros and cons of a stock.

Initial public offerings and Reverse Mergers

The price and market discussion above relate to penny stocks already trading in the market. Stocks are introduced into the market through an initial public offering (IPO). In most cases, an IPO would need to be registered with the Securities Division, which applies a set of guidelines to the offering to determine whether the offering is "fair, just and equitable." Although the "merit" system of applying those guidelines is not foolproof, fraudulent offerings are rejected and not granted registration. For this reason, Investors are not usually victims of penny stock scams in an IPO, but lose their money in the secondary market. In the secondary market, there are broad exemptions in the law that allow many penny stocks to trade without meeting the merit standards.

Another kind of IPO or way for a company to begin trading is through a reverse merger or merger. When a company that is listed on the OTCBB or Pink Sheets goes out of business it doesn't always mean the stock goes to zero and stops trading. Many times the management or majority stock holders will maintain the listing of the stock by continuing to meet the requirements of the listing exchanges as described above.

These companies become shells or companies with nothing but their stocks and no real business. A company that wants to go public can make a deal with these shell companies. These deals usually end up with the old companies stock holders getting some cash and stock in the new company this is called a reverse merger.

Legitimate penny stocks

Despite all of the problems with penny stocks and the millions of dollars of loss involved with them, there are legitimate companies whose securities trade in the pink sheets and OTCBB at very low prices. Struggling young companies just starting out are perfect examples. Investment in such a company, held through the company's formative years, can pay off well. Such an investment may require lots of research and a deep understanding of the company its markets and other information. We listed a few of the questions most investors will want to ask here.

Trading or Investing?

Traders of penny stocks will often become longer term investors as their intended profitable day trade becomes a looser if sold so they will often hold for days weeks and even longer waiting for the next pop in the price.

Many times if an investor finds the right company, they must be able to hold the investment for years to allow the company to mature and for the stock to appreciate in value. Investment in "growth" companies can be long-term investments. Furthermore, you must have sufficient capital to be able to withstand total loss of your investment. Investment in emerging companies is always a high-risk investment.

Finally, there is simply an element of luck in any stock investment. Luck plays an even greater role in a market in which manipulation is so prevalent. Some legitimate companies have had their stocks manipulated to such an extent that they were forced out of business. Even without manipulation, the success or failure of a fledgling business is simply unpredictable.

Sources of information

Your broker or registered finical advisor can be a tremendous help in evaluating investments.

However, in the penny stock and micro cap area, there are many unscrupulous brokers whose only goal is to sell. Be sure that the advice you receive is balanced and addresses your investment needs. When in doubt, don't buy a penny stock investment.

The prospectus is the most comprehensive source information about an IPO. It sets out where your investment money will be used, describes the capitalization, history and management of the company and describes the cash flow system of the company.

Web sites such as and OTCBB have links to information.

Periodic reports filed with the U.S. Securities and Exchange Commission have updated information about companies that register with the SEC.

Warning signs

Watch for the following warning signs to alert you to a possible penny stock Pump and Dump or manipulation.

High-pressure sales techniques. Investment in a legitimate emerging company is long-term. A good little company is not going to skyrocket in a couple of weeks. Building a sound company takes years; you may have a few days or even years  to decide whether the investment is right for you.

Mismarked trade confirmations or new account cards. Be very wary if your trade confirmation is marked "unsolicited" if your broker did, in fact, solicit the trade. While it may be a simple mistake, unscrupulous penny stock brokers often mark the confirmation as unsolicited to avoid the registration laws and the "fair, just and equitable" standard. Watch for misstatements about your net worth, income and account objectives as well. Investing in penny stocks is speculative business and involves a high degree of risk. Often, brokers will enhance the new account card to make it seem that you are suitable for a penny stock investment when you are not.

Investigate before you invest

Millions of dollars are lost in the penny stock markets each year. Those few who make money in the market are largely investors in legitimate, fledgling companies. Before you invest in any penny stock, read about the company. Do not allow yourself to be pressured into a transaction that is not right for you. Check out the broker-dealer, the salesperson and the stock itself with the SEC. The Securities Division registers broker-dealers and their salespeople and has information about their complaint histories and other information about their experience in the securities business.

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