In order to understand what a Penny Stock is, one must understand the stock market indexes. The best known indexes in the United States are the Dow Jones Industrial Average, the S&P 500 Index, the Nasdaq Composite Index and the Russell 2000 Index. These Indexes are very important as they are used to measure not just the performance of the stock markets in general, but also the state of the overall economy as well.

Each of these Indexes is formed in a slightly different way. For example, the Dow Jones Industrial Average Index contains 30 different stocks that represent various different industries. On the other hand, the S&P 500 Index will contain stock of the 500 largest US companies, the Nasdaq is the largest electronic screen-based equity securities trading market in the US, the Russell 2000 Index contains the bottom “small-cap” 2,000 stocks in the Russell 3,000 Index. Small-cap refers to the market capitalization of a business and describes the size of that business corporation. Thus the Russell 2000 is formed with the stock of the smaller corporations. These indexes are mainly used by institutional investors , such as mutual funds. Quite often, the mutual funds are required to own the stocks that are part of the index, they become their index portfolios. For example, a S&P Index mutual fund will have to own the 500 stocks that form the S&P 500.

The Penny Stocks are more easily found in S&P main US indexes: the S&P 500, which covers the highest range of stocks, the S&P Midcap 400 Index which covers, as its name indicates, the mid-cap range of stocks, and the S&P SmallCap 600 Index, which covers the lowest range of stocks.

The way these different indexes are maintained also differs. The Dow Jones Industrial Average does not change very often, that means that its stock base does not move about, changes in the stocks that are traded happen every so many years. The S&P Index, on the other hand, move stock around several times a year. This has a direct importance when talking about Penny Stocks as we will see in a moment.

S&P maintain their indexes through a committee which keep an eye on the state of the companies that are already part of the Indexes and on those companies which are being considered to join any of the Indexes. The committee is in charge of adding stocks or indeed, if a company is not performing well, removing the stock from the Indexes. Once these stocks have been removed from the S&P Indexes, they will also be rejected by institutional investors such as fund managers. These stocks are called Wall Street castaways or Penny stocks!

Not all the stocks that are removed from the Indexes will turn out to be profitable. There are different reasons for a stock to be removed from the Indexes. The more straight forward delistings can be due to a merger or an acquisition within the company, or a spin-off, corporate restructuring or bankruptcy. The stocks that are removed through those reasons will not be good stock for making a profit. There are a different set of reasons a stock will be removed for, these are generally due to the stock no longer meeting S&P\’s guidelines. These can include low market capitalization, lack of representation, that is has traded below $2.00, or that it ranks in the last place in their list of stock. It all means the same, the stock is not performing how S&P would like it to, so it is removed from the Indexes. These are the Penny Stocks that can be bought for profit.

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Category: Finances
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