What Are Penny Stocks?
Penny stocks refer to smaller stocks of small companies that trade at lower than 5$ a share. Some penny stocks trade on exchanges, while most are bought and sold through over-the-counter (OTC) transactions. Penny stocks are most often stocks of small companies that trade at a price of a few dollars. Some years ago, all stocks trading below $1 were categorised as penny stocks by the SEC (U.S. Securities and Exchange Commission). However, today the definition encompasses all stocks that trade at lower than $5.
Normally penny stocks suffer low liquidity which makes it hard for investors to enter and exit their positions. Low liquidity also makes penny stocks the perfect target for market scams such as pump and dump scams, which is a danger that investors need to consider.
As we are about to learn, penny stocks are for risk-taking investors. However, in order to capture those high returns that accompany high risks, understanding Penny Stocks is a prerequisite. In this article, we will cover what penny stocks are, what risks are involved, and if you should invest in penny stocks or not.
Should You Invest In Penny Stocks?
Judging whether different investments such as Penny Stocks are useful to an investor depends on why the investment is being made.
In general, there are two types of investors:
- Professional investors who invest for a living.
- Investors who actively strive to maximise their returns from their savings.
It’s becoming ever more necessary to join one of these two groups. This is because in today’s world, you need returns on your investments to fight against inflation of important products and services. Take the example of college education. According to Finaid, a girl born today will have her tuition fee quadrupled by the time she turns 18. In such inflationary times, saving without investment is simply not an option.
Investing in Penny Stocks can be a good option for both types of investors, if risk all the risks, which will be covered later, are managed correctly!
What To Consider Before Buying Penny Stocks
An investor has to ask themselves two questions before deciding to invest in Penny Stocks or not.
First, they have to ask themselves if they cope with the volatile nature of Penny Stocks. Penny Stocks differ from other investments because of their volatility and lack of security and are at the higher end of the spectrum when it comes to volatility. Therefore, prudent investors rarely hold a majority of their wealth in Penny Stocks. Furthermore, Penny Stocks are less secure because they are open to scams and are often issued by firms with very weak fundamentals. Therefore, a stomach for uncertainty comes in handy when investing in Penny Stocks.
Second, if investors decide on investing in Penny Stocks, they have to figure out what category of penny stocks they want to invest in. Officially, the SEC considers stocks under $5 to be Penny Stocks. However, experience shows that lumping all Penny Stocks to be under one price is a mistake and one of the best ways is to categorise them on the basis of their price. That Price in-turn determines the types of stock issuers, level of security, volatility levels and the best strategy for investing. It’s an investor best practice to categorise Penny Stocks into four price ranges. Below you see an example of how investors could rank penny stocks into different risk levels depending on their price.
As you can see, the lower the price, the higher the risk:
|1||NYSE or NASDAQ Grade Stocks||$1 to $5|
|2||Slightly Dangerous Stocks||Under $1 to $0.01|
|3||Toxic Stocks||Under $0.001|
|4||Bait Stocks||Under $0.0001|
Where Do Penny Stocks Trade?
1. On Exchanges
Those stocks that sell in exchanges such as New York Stock Exchange (NYSE) are less risky than OTC stocks. This is because the very requirements for being placed on the exchange is a mark of competence for the enlister. In contrast, entering into OTC markets is much easier, especially as a Pink Sheet stock. Ease of entry invites compromised firms into the market. These compromised firms then take unlucky investors for a ride that only ends with lessons that are learnt the hard way.
2. Via OTC:s
OTC counters have much smaller volumes of trade as compared to stock exchanges. This lack of liquidity has some serious implications on realising returns from one’s investment. Let’s say an investor knows that the price of their stock has peaked and would like to realise their returns. If he owns 100,000 shares, he might be surprised to find that he can only sell a thousand shares a day. This will force the investor to either drop the price or only realise 1/100th of his/her potential returns. Though Penny Stocks may be sold via different fronts, the firms issuing them have some very basic common characteristics.
Pros of Investing in Penny Stocks
Let’s start with the advantages:
1 Investments Can Rise to The Sky
For starters, Penny Stocks do provide a big advantage for the stock broker in terms of potential returns. There is no other market where returns of 1000% can be repeated over and over again, that too in short-term investing.
2 Low Capital Requirements
Apart from giving good returns, Penny Stocks offer very low starting investment. With $5 one can own 1,000 shares in five different companies. This means that anyone can enter the Penny Stocks market without compromising their family budget.
3 Opportunity to Catch Trends Before They Start
Third, Penny Stocks allows an investor with niche knowledge of an industry to cash in on their knowledge. An example in today’s world would be cannabis stocks. A person who is intimately aware of cannabis production will be able to select the right Penny Stocks that might become a star stock of the future.
Cons of Investing in Penny Stocks
In contrast to these three strong advantages, Penny Stocks also have a lot of disadvantages as well.
1.Require Active Attention
For starters, Penny Stocks are very volatile. This makes them a bad option for passive investment. This means that investors who don’t invest for a living have to actively watch their investments in order to make good returns. This might not be possible for some investors who have to work day jobs or take care of household chores.
2. Illiquid Investments
Apart from requiring active attention, Penny Stocks are also not the most liquid of the investments. Lack of liquidity can be a problem for middle-class income individuals as well as for investors with large holdings who want to capitalize on their returns.
3. Not Really an Investment
Lastly, and most importantly, Penny Stocks investment is not actually investment but more of a speculation. This is because the types of firms that issue Penny Stocks are very unreliable and require insider information to make good returns.
4. Risk of Buying a Scam
Third, Penny Stocks are also some of the most scam ridden investment options in the market. These scams come in all shapes and sizes and could make you incur great losses!
Of course, all these disadvantages will have the greatest impact if investors forget to consider them while investing. After considering the Pros and Cons of Penny Stock investment, if an investor decides to take the plunge, they will need to know the strategies of this market. Knowing a strategy and not acting on a whim is key to making money on penny stocks!