What Are Penny Stocks and Microcap Stocks — In Plain Words

This page is educational only. It is not financial advice.

Short answer

“Microcap stock” is the U.S. Securities and Exchange Commission (SEC) name for the stock of a company with a low or “micro” market capitalization — the total value of the company's stock. The SEC says microcap stocks are often known as penny stocks. Many of them trade in the over-the-counter market, not on the major exchanges. The SEC's warning comes first on this page because the SEC puts it first in importance: while all investments involve risk, microcap stocks are among the most risky, and they may be susceptible to fraud and manipulation.

This page prints what the SEC bulletins state, in plain words — definitions and risks only. It does not judge any company or any stock, and it gives no way to pick or buy one.

The risks — the heart of this page

Part 3 of the bulletins is a list of risks to consider. Part 1 states the same warning in short form. Together, the bulletins state these risks:

• Many of these companies are new, with no proven track record. Some of these companies have no assets, operations, or revenues. Others have products and services that are still in development or have yet to be tested in the market.
• Lack of public information. Often, the biggest difference between a microcap stock and other stocks is the amount of reliable publicly-available information about the company. Information about microcap companies can be extremely difficult to find. That makes them more vulnerable to investment fraud schemes, and makes it less likely that quoted prices will be based on full and accurate information about the company. If the company is not subject to SEC reporting requirements, investors may also have trouble obtaining information about the management, operations, financials, and other important aspects of a company.
• No minimum listing standards. Companies that list their stocks on national securities exchanges must meet minimum listing standards — for example, minimum amounts of net assets and minimum numbers of shareholders. Companies whose securities are quoted in the over-the-counter market may have to meet the minimum criteria imposed by the trading system, or be subject to minimum criteria to be eligible for quotation in certain tiers maintained by the system. Rule 15c2-11 restricts the ability of broker-dealers and other market makers from publishing quotations for companies of over-the-counter stocks that have not provided current and publicly available financial information.
• Lack of liquidity. A stock's liquidity generally refers to how rapidly a stock can be bought or sold without substantially impacting its price. Stocks with low liquidity may be difficult to sell, increasing the possibility that you may sustain a more substantial loss if you cannot sell the shares when you want to. Historically, microcap stocks have been less liquid than the stocks of larger companies. Because many microcap stocks trade in low volumes, any size trade can have a large percentage impact on the price of the stock, and a sale can have a noticeable impact on the stock's selling price.
• High volatility. A stock's volatility generally refers to how much its price may change in a short period of time. Stocks with high volatility generally experience large price changes in a very short period of time. While all stocks experience volatility to some degree, microcap stocks have historically been more volatile than stocks of larger companies, and may be susceptible to sudden large price changes — particularly in light of the potential difficulty in selling them.
• Fraud. Reliable publicly-available information about microcap stocks is often limited. Also, the stocks of microcap companies are historically less liquid and more thinly traded (lower volume) than the stocks of larger companies. These factors make it easier for fraudsters to manipulate the stock price or trading volume of microcap stocks.

Red flags of fraud — the bulletins' full list

Part 3 lists these “red flags” for microcap companies:

• SEC trading suspensions. The SEC has the power to suspend trading in any stock for up to 10 days if, in the SEC's opinion, it is in the public interest and will protect investors. This can occur if it appears to the SEC that there is a lack of current and accurate information concerning the company and its stock. The bulletin says to determine, before investing, whether a company's stock has been the subject of an SEC trading suspension, and that information about trading suspensions can be found on the SEC's website.
• Stock promotions (including email, text messages, and social media sites recommending a stock). The bulletin says, in bold: carefully consider whether a company's stock seems to be more heavily promoted than its products or services. Microcap stocks are particularly vulnerable to “pump-and-dump” schemes. These can occur when paid promoters or company insiders make false and misleading statements to create a buying frenzy and then quickly sell their shares before the hype ends. After the promoters profit from their sales, the stock price typically drops and investors lose money. The system on which the over-the-counter stock is quoted may flag information about recent stock promotions.
• Unexplained increases or decreases in stock price or trading volume. The bulletin says to carefully consider whether you should invest in a company's stock if the historical price or trading volume of the stock shows dramatic increases or decreases for no apparent reason, as this may suggest manipulation.
• No history of operational success. The bulletin says to use caution before investing in a company's stock if the company has no history of operational success, yet still projects large future revenues — especially if the projections appear based solely on information about the company's industry rather than on the company itself.
• Insiders own large amounts of the stock. In many microcap fraud cases — especially “pump and dump” schemes — the company's officers and promoters own significant amounts of the stock. When one person or group controls most of the stock, they can more easily attempt to manipulate the stock's price. The bulletin says you can ask your broker or the company whether one person or group controls most of the company's stock; however, accurate information may not be available. It also says to consider whether a company issues financial instruments that are convertible into equity/stock positions, as this could mask control over large portions of a company's stock.
• No real business operations. Frequent or unexplained changes in company name or type of business, little or no assets, minimal revenues, or implausible press releases may suggest no real business operations.

Other considerations the bulletins list

• Be aware that dormant shell companies that continue to trade may be aggressively promoted and are susceptible to market manipulation.
• Look closely at a company that became public through a reverse merger.
• Look closely at a company that has recently undergone a reverse stock split (reducing the number of shares and increasing the share price proportionately), particularly when the reverse stock split also accompanies a reverse merger in a short time frame.
• Review independent information about the company's management and its directors. Consider whether these individuals have background or expertise in the business of the company.
• Cautiously examine any unsolicited (you didn't ask for it and don't know the sender) stock recommendation.
• Never deal with brokers who refuse to provide you with written information about the investments they're promoting.
• Unless you are accessing an account that you established, do not provide bank or brokerage account numbers, passwords, PINs, credit card information, Social Security numbers, or other personally identifiable information online or over the phone.

What a microcap stock is

The term “microcap stock” (sometimes referred to as “penny stock”) applies to companies with low or micro market capitalizations.

Companies with a market capitalization of less than $250 or $300 million are often called “microcap stocks” — although many have market capitalizations of far less than those amounts.

The smallest public companies, with market capitalizations below $50 million, are sometimes referred to as “nanocap stocks.”

The bulletins use the term “microcap stock” to refer to both microcap stocks and nanocap stocks.

Where microcap stocks trade

Many microcap stocks trade in the “over-the-counter” (OTC) market.

Quotes for microcap stocks may be available directly from a broker-dealer or on OTC systems such as Global OTC ATS, and OTC Link ATS, among other venues.

Global OTC ATS, and OTC Link ATS (as well as other venues) are operated by broker-dealers registered with FINRA and are required to file Form ATS notices with the Commission.

Why information about them is hard to get

Investors may have difficulty finding accurate, complete and current information about microcap companies.

Many microcap companies do not file reports with the SEC, so it's hard for investors to get the facts about the company's management, products, services, and finances.

Most large public companies file reports with the SEC that any investor can get for free from the SEC's website. Professional stock analysts regularly research and write about larger public companies, and it is easy to find their stock prices on the Internet or in newspapers and other publications. In contrast, the same information about microcap companies can be extremely difficult to find.

Part 2 also warns that you should never use unsolicited e-mails, message board postings and company news releases as the sole basis for your investment decisions. Some of the information you receive may be false or misleading, or may be distributed by persons with an undisclosed interest in causing investors to buy stock for more than it is worth.

Part 2 names these places information can come from: the company itself; the SEC, through its EDGAR database; your state securities regulator; other government regulators, for companies such as certain banks that file with their banking regulators instead; reference books, websites and commercial databases; and the Secretary of State where the company is incorporated.

Part 2 states this warning in capitals: just because a company appears to have readily available company information or files reports with a regulator, does not mean it's safe to invest in that company. You should always carefully consider any investment decision.

This page is educational only. It is not financial advice.