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What are penny stocks?
There is no set, accepted definition of penny
stock. Some people define it as stock priced under one dollar, some
under five dollars. Some people include only those securities traded
in the "pink sheets," some include the entire OTC market.
What
is a stock exchange?
Stock exchanges have specific quantitative
and qualitative listing and maintenance standards which are stringently
monitored and enforced. Companies listed on an exchange have reporting
obligations to the exchange and a direct business relationship exists
between the exchange and its listed companies.
What
is the OTC Market?
The OTC market consists of unlisted securities. Issuers of these
securities often have no reporting obligations to any federal regulatory
authority (non-reporting). There are no minimum required standards
and no business relationship exists between the quotation services
(OTC-Bulletin Board, "Pink Sheets") and the issuers.
Where
are penny stocks traded?
Penny stocks are not traded on a stock exchange,
but are traded in the over-the-counter (OTC) market. Part of the OTC
market is the National Market System (NMS) of the NASDAQ (National
Association of Securities Dealers Automated Quotation) System, which
does not include any penny stocks.
There are also non-NMS NASDAQ securities, including
some penny stocks. The NASDAQ system has listing standards that change
from time to time and, depending on the standards, there may be more
or fewer penny stocks on NASDAQ. If you purchase a low-priced security
that is listed on NASDAQ, it will meet certain minimum standards.
In addition, many NASDAQ prices are quoted regularly in newspapers,
allowing you to follow the price of your security instead of forcing
you to rely on your broker for all price information.
The third major 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,
printed on pads of long, narrow sheets of pink paper, have, for all
practical purposes, no meaningful listing standards, and price information
is sometimes difficult, if not impossible, for the small investor
to obtain. Broker-dealers obtain their price information by calling
the trading desks of three "market makers." Obviously, small investors
do not have access to those traders and must rely on their stockbroker
for accurate price information.
What
is the effect of the new reporting requirements for OTCBB companies?
On January 7, 1999, the Security and Exchange
Commission (SEC) signed an order approving the proposed amendments
to NASD Rules 6530 and 6540 to limit quotations on the OTC Bulletin
Board™ ("OTCBB") to the securities of issuers that are current in
their reports filed with the SEC or other regulatory authority, and
to prohibit a member from quoting a security on the OTCBB unless the
issuer has made current filings, respectively. All companies will
have to become "reporting" companies. Many OTCBB companies do file
with the SEC. These filings may be retrieved online from the SEC EDGAR
Database. Those companies that do not comply within the required time
will and are being dropped from the OTCBB. These companies can still
be quoted OTC if they have submitted their Form 15(c) 2-11 to the
OTC Compliance Department of the NASD.
How
do the Principal or Agency rules work when I buy a stock?
In most securities transactions, your broker-dealer acts as your
agent, arranging a transaction directly between you and a third party.
In compensation for arranging that trade, you pay your broker-dealer
a commission. In some instances, the broker-dealer has the security
you seek to purchase in inventory, or wants the security you wish
to sell. The broker-dealer may trade with you on its own behalf, as
a principal in the transaction. When the broker-dealer acts as a principal,
and not as an agent, the trade confirmation should say that on its
face. The broker-dealer is not paid a commission in principal trades,
but makes its money on the spread, and by buying and selling at advantageous
times, the same as any other investor. A sizeable portion of penny
stock trades are principal transactions, and an investor should be
alert to the potential conflicts of such transactions.
What
are the Bid and Ask Prices?
Penny stocks do not each have a single price at which they are bought
and sold, but a number of different prices. The first difference is
between the bid price and the ask price. The bid price is how much
someone is willing to pay for the security, or the price at which
you could sell your shares. The ask price is how much someone will
sell their securities for, or how much you will have to pay. The difference
between the prices is the spread.
How
does the Spread work?
To most investors, the spread represents a built-in loss at the time
of investment. For example, if you purchased a stock that traded at
1/2 cent bid, 1 cent ask, 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 "ticket" charges and other miscellaneous costs). Many
investors buy penny stocks believing that "trading at 12 cents" means
that they can buy and sell at 12 cents. This simply is not the case,
and any salesperson who uses such a phrase is only telling half of
the truth. The spreads in penny stocks are most commonly 25-33%, are
often 50-100% and sometimes are over 100%.
What is
the Inside Bid and Ask and the Outside Bid and Ask?
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.
What
are Mark-ups?
The last pricing factor concerning penny stocks is called the mark-up.
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.
How
do I get a better price?
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 mark-up.
What
are Market Makers?
A market maker is a broker-dealer who stands ready to buy or sell
100 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 first 100 shares. While the market maker system has been
widely criticized (after all, how much of a commitment is it to buy
100 shares at a penny apiece or less?) 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. The names of
the market makers of securities traded in the pink sheets are listed
in the pink sheets.
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