Why is 5-dollar level so important in stock investing?

Answer 1

Perceived Risk - There are almost no companies that have gone public at a price below 5-dollar level. Thus, for a company that trades under $5 there is a big chance that some serious operational or financial problems have accrued in the past or recently, and there is plenty of statistics suggesting that $5 stocks frequently go to zero.

Margin - Margin is a line of credit given to an investor so that they may make investments in amounts larger than their current funds would allow. This allows investors the ability to leverage their current holdings and make larger investments hoping that the return will be larger than the interest for the loan. These investors are taking on a larger amount of risk and so are the firms that loan the funds to the investor. Because of this most firms deem stocks under 5 dollars to be unmarginable. This means that they will not extend a line of credit on investments that are trading at less than 5 dollars. They do not feel that a stock trading under 5 dollars is good collateral. Some set the mark higher or lower but 5 dollars is the most common. They do this because of the higher risk associated with lower priced stocks. Brokerages worry that they may not be repayed if substantial losses are realized in a short period of time. These facts make unmarginable stocks or stocks trading under the 5 dollar mark less attractive to the investment public including institutional investors and hedge funds.

Penny Stock Notoriety - A "penny stock," according to SEC interpretation, is an equity trading for less than $5 a share that is not traded on the listed markets of the NYSE, AMEX, or NASDAQ. This perception of riskiness in sub-$5 dollar stocks outside the major exchanges has definitely influenced the perception off all sub-$5 stocks, even those highly liquid and more transparent exchange traded stocks.

Note: Many consider penny stocks to be stocks that trade for less than a dollar which are listed in cents (pennies) as in .87 cents or pennies.

Institutional Investors - Many mutual funds' charters directly prohibit their managers from investing or holding penny stocks (those traded on the OTCBB and pink sheets) and generally stocks under $5 dollars. However, mutual funds are not obligated by any regulations to have such clauses and there are mutual funds that specialize in penny stocks.

Government Influence - To the extent that municipal, state, or federal pension funds' charters might prohibit their managers from investing in stocks (or holding stocks) below 5 dollar level, we can talk about government involvement in discouraging investments in stocks trading below $5.

Retail Constraints - Many brokerage houses and investment professionals strongly discourage trading in speculative stocks. Often their customers must sign extra paperwork acknowledging that they are aware of the risks of trading such stocks.

See the related link below for an interesting article on the subject.