Penny Stock
A penny stock is a share that costs less than $5 and is from a small company. They are often considered high-risk investments because they have a low price, not much liquidity, small market capitalization, and a wide bid-ask spread. Therefore, company ABC's stock is considered a penny stock. Penny stocks are high-risk securities with small market capitalizations that trade for a low price outside major market exchanges. A lack of history and information, as well as low liquidity, make penny stocks riskier. Look out for scams involving penny stocks that want to separate you from your money.
WHAT ARE PENNY STOCKS?
Penny stocks are usually associated with small companies and they don't trade very often. That lack of liquidity might make it hard for investors to sell their stock, since there might not be any buyers at that time. And because there's not much market activity, investors might have difficulty finding a price that accurately reflects the market.Penny stocks are usually small-cap stocks that are worth less than $250 million or $300 million. Most of these stocks are traded over the counter. But, some may be traded on the big stock exchanges such as NASDAQ or the New York Stock Exchange. These stocks that are traded on big stock exchanges are usually the better known companies with a higher market capitalization. Penny stocks can be a great way to get started in the stock market. However, it is important to do your research before investing in any stock, especially penny stocks.
INVEST
HOW DO PENNY STOCKS WORK?
Penny stocks are more volatile and difficult to sell than regular stocks, making them very risky investments. With lower volume, penny stocks are traded less frequently, meaning that there are fewer buyers and sellers. This can make it difficult to find someone to buy your shares when you want to sell, which is why these investments are considered less liquid. Additionally, penny stocks are more susceptible than regular stocks to large price swings. All of these factors make penny stocks dangerous investments.
Due to their lower per-share price and smaller market capitalization, penny stocks carry increased risk and are made up of highly speculative, unproven companies. With less coverage from large institutional investors, these stocks offer less information making it tougher to make sound trading decisions. Because they are not required to file with the SEC, the information that is available is often less credible.
BENEFITS OF PENNY STOCKS
LOW SHARE PRICE
Investing in penny stocks can be advantageous because they are relatively low-cost, meaning that even small amounts of money can be used to purchase them. You don’t need to invest a lot of money. This becomes beneficial for investors on a budget. The price of a share of Warren Buffet’s Berkshire Hathaway is more than $400,000, a majority of the investors worldwide would not be able to afford even one share of Berkshire Hathaway, but they have the opportunity to buy thousands of penny stocks with less than 1% of the same capital.
GET RICH QUICK
Penny stocks’ major attraction is the potential to get rich quickly. Penny stocks are issued to raise equity capital for small companies just entering their respective industries, companies emerging from bankruptcy, or growing companies that are still flying below the investment analysts’ radar screens. Most penny-stock companies are small fry with big dreams, living in the backwaters of the investment world. But if they are discovered by the investing mainstream, the stock price could explode upward in a matter of weeks or even days.
POSSIBILITY OF MULTIPLE RETURNS
The most significant edge provided by penny stocks is that they have the opportunity to grow rapidly. Penny stocks offer a great way for retail investors to compound their initial capital, and quite a few highly acclaimed great investors today have been blessed by penny stocks in one of the previous bull markets. Due to a lack of liquidity, institutional investors can not capitalize on penny stocks as much as retail investors. In a way, penny stocks provide retail traders with an edge over institutional traders but with a significant risk associated.
LOW LIQUIDITY
Since many of the penny stocks are traded over the counter, the liquidity of the stocks is low. An investor may not always be able to sell the shares at the right time. Also, the low liquidity results in low trading volumes. Thus, even relatively small transactions can cause large swings in the price of the shares.
VOLATILE
Penny stocks are traded in small lots among a handful of investors, which can exaggerate price swings. These stocks can shoot up in price very quickly but also drop in price just as fast. Penny stocks are not for the buy-and-hold investor or anyone with a low-risk tolerance. Investors need to keep close tabs on their stocks and sell when they show a fat profit.
Holding onto a penny stock too long can turn a tidy profit into a dismal loss. But the thin market for penny stocks may make it hard to find a buyer when you want to sell. In situations where the lower circuit or the upper circuit is being hit continuously for a couple of days, it becomes impossible for traders to exit their positions, causing them huge losses. This type of unexpected event needs to be considered before making allocations in penny stocks.
DRAWBACKS OF PENNY STOCKS
PRICE MANIPULATION
Penny stocks can move tremendously since they usually belong to very low market capitalization companies. Any high network individual or institution can easily sway the price of penny stock by purchasing a sufficient amount of shares of that stock and further reducing the number of shares left for trading. There are many instances when the prices of penny stocks are artificially inflated and then dropped; market participants with big money might indulge in such pump and dump schemes to profit off small and uninformed market participants. Thus, a risk of being manipulated is always there in penny stocks.
LIMITED INFORMATION
Since penny stocks are usually issued by a startup or growing companies, there is hardly any information available about the company's history and its financial soundness. Therefore, there are high chances that you could invest in a company that may not have growth prospects leading to a decline in share prices.
It is important to have thorough research about the company's fundamentals before investing. A SEBI registered investment advisor can help you in conducting fundamental research about a company.
HIGH RISK
Penny stocks can lose money as quickly as they make it. The low price of the stocks may be an indicator that the company is not doing well, making them highly risky. The returns may be high, but so are the risks. Hence, penny stocks should be considered only by experienced investors who are willing to take huge risks.
LOSS OF CAPITAL POSSIBLE
A complete loss of capital deployed is possible with penny stocks since they belong to small companies. Small companies are the most prone to bankruptcy in instances of financial distress. Even though there is a possibility of default in large-cap and mid-cap stocks, the probability of default in such stocks is low, and even if there is a default, the loss given default is rarely 100%. Because there is a possibility of complete loss with penny stocks, an investor should limit the exposure in such stocks to risk capital.
PRONE TO SCAM
If we take a look at the history of scams, penny stock scams have been very common. One of the common scams associated with penny stocks is the Pump and Dump strategy, where companies and fellow investors buy a considerable number of shares to inflate the prices, which attracts other investors to buy the stocks.
COMMISSION COSTS COULD COST YOU A TON
Most brokerages charge a fairly streamlined commission for Motley Fool stock picks on indexes such as the NYSE. For penny stocks, there is often a substantially higher commission charge. Be aware of this before you sign up as it could cost you dearly. One broker that doesn’t raise commissions for penny stock trading is Questrade.
SHOULD WE INVEST IN PENNY STOCKS?
Penny stocks are considered a hit or miss investment option. When invested with proper research, there are chances that these stocks can be multi-baggers. It means that the stock can provide returns, multiple times the initial investment price. If the stocks return ten times the value of the investment, they are known as ten baggers. Many beginner traders start their trading journey with penny stocks.
These are stocks that have the potential to make 20-30% intraday moves while still being listed on NYSE and NASDAQ. As a result, they are more popular among traders and investors because they are seen as safer vehicles for trading and investing. Also, the availability of these stocks at low prices allows you to invest in large quantities with nominal capital. Including them in your portfolio can be very beneficial from the diversification point of view. These stocks at times can even outperform midcap and blue-chip stocks of your portfolio.
Penny stocks are sometimes seen as a way to get rich quickly. They don’t cost much to own, so people see trading penny stocks as an easy way to start investing. If you’re buying shares at a super low price, it wouldn’t take much of an increase to get rich, right? In general, you should avoid penny stocks like the plague. Penny stocks are high-risk securities with small market capitalizations that trade for a low price outside major market exchanges. A lack of history and information, as well as low liquidity, make penny stocks riskier. Look out for scams involving penny stocks that want to separate you from your money.
HOW TO INVEST IN PENNY STOCKS?
Penny stocks attract investors for many reasons. Most notably, you don’t need a huge bankroll to get started, and you can trade with confidence knowing that you don’t need to put as much money on the line compared with other account types to start trading.
UNDERSTANDING PENNY STOCKS
Penny stocks are defined as securities issued by small-cap or micro-cap companies that have a market capitalization of less than $250 million. Others define penny stocks as those that trade at less than $5 per share (though some experts choose to adopt a lower cut-off value of $1 per share). They often have little or no financial history, or a bad one: The underlying company may be close to bankruptcy. In other words, penny stocks are the opposite of blue-chip stocks.
DON'T INVEST A LARGE AMOUNT
Don’t lean too much on these risky investments. Penny stocks should not account for more than 10% of your total equity portfolio. This means if your total investment portfolio is Rs 20 lakh and 30% (or Rs 6 lakh) is in stocks, then the maximum you should put in these high-risk stocks is Rs 60,000. Invest only what you can afford to lose.
UNDERSTAND THE MARKETS
Investing in penny stocks requires a good understanding of the stock markets. There are various factors that drive stock prices like a war, election, natural disaster, change in government policies, the introduction of new technology, etc. Since these are not fundamentally strong companies, they react strongly to even minor events. Hence, investors with a sound understanding of the stock markets are usually better at picking penny stocks than novices.
Also, since the price is low, many companies or even individuals might manipulate the demand for such stocks by buying them in bulk. Once the price jumps due to an increase in demand, they sell in bulk too causing the prices to nosedive. Therefore, ensure that you understand the markets thoroughly before looking in this direction
RESEARCH
In the stock market, a majority chunk of stocks is small-caps and lower. Hence, when you start looking for penny stocks, you will have hundreds of options. Most people investing in large-cap or mid-cap stocks are used to creating a shortlist of companies that they want to invest in and then analyzing the company’s fundamentals to arrive at the final list of stocks that fit into their investment plan. With penny stocks, this strategy would need to be tweaked a bit. You will then start weeding out names and try to find the few who have the best chance to turn into multi-baggers. With time and experience, you will be able to create filters based on macroeconomic events too.
BUY STOCKS WITH HIGH VOLUMES
Some penny stocks are very thinly traded. For instance, the average daily volume of Titan Securities for the past 1 month has been only 3 shares. So if you have 5,000 shares of the company, it will be quite difficult to offload them when you want to exit the stock. Buy stocks that have reasonably high trading volumes so that there is ample liquidity. Don’t look only at one day’s trading but consider the monthly average.
Penny stocks can prove out to be a great investment option if you can identify multi-bagger stocks. Detailed research into the fundamentals of the company can give you an idea about the future of the stocks and help you in selecting the best stocks for your needs. Illiquidity is one of the biggest risks associated with penny stocks and can block your capital for months or years. Therefore, always have your risk profile evaluated before planning and investment. Happy Investing!
