There is no universal definition of what a penny stock is, based purely on price. However, these stocks are generally those that trade at prices that are comparatively lower than the typical share prices.
For example, a penny stock in the United States is one that is traded for less than $5. In contrast, the threshold in the UK is £1. Alternatively, they are defined as stocks whose market capitalization is less than $300 million, otherwise commonly known as microcaps. Only a few of these stocks are traded in large stock exchanges, with the majority traded over-the-counter.
Penny stocks are not significantly different from other stocks. They are bought and sold using the same mechanism as standard stocks. However, they are susceptible to speculation, which often makes them highly volatile. In addition, they have a comparatively lower traded volume, which translates to low liquidity.
These factors have rendered them unpopular among some investors and make them a relatively high-risk investment.
The pump and dump trap
The low trading volume and high volatility in penny stock markets predispose them to artificial momentum-creation from fraudulent traders. One of the most common ways used to defraud unsuspecting investors is a scheme known as “pump and dump.”
In this strategy, a group of scam artists come together and agree to artificially pump up the prices of their targeted stocks with no concrete changes in market fundamentals to back up the skyrocketing prices.
In effect, the high prices attract unsuspecting and inexperienced investors, who use large sums of their money to buy the penny stock. However, as soon as the fraudsters realize that new buyers have come in droves and are buying at high prices, they strategically dump large amounts of the stock within a very short time, sending the stock prices plummeting.
They then take their fraudulently earned profits and disappear from the market. Such scams are especially common in offshore markets, and some brokers even participate in the fraud by marketing such stocks to reap the high commissions that come with it.
Trading penny stocks
As cited earlier, penny stocks can be a minefield due to their susceptibility to fraudulent activities. Therefore, investors should not simply believe the hype but conduct their due diligence to ensure that the company they intend to invest in is worth the stock prices.
Strive to go through available company financial records and look at factors such as EPS, P/E ratio, etc. and gauge them against the share price. Some of these records can be obtained from the SEC or even your broker.
Due to the high-risk exposure that comes with penny stocks, it is advisable to assess your ability to effectively trade in them by using virtual currency. This will require you to have a demo account, and it will help you learn how to handle the price and volume fluctuations, carry out technical analysis, the best indicators to use, etc.
If you realize that you are capable of profiting from these stocks, you can then transition to trade with real money.
You should also know the company’s actual financial state. Some investors mistakenly put their money in penny stocks hoping that the shares will rise significantly to go beyond $5 or £1. However, this is not an easy feat. Instead, you should look at the company’s stock price and outstanding shares to help you evaluate its true value.
A detailed look at the risks that come with penny stocks
There is a big divergence between absolute figures and market percentages when trading penny stocks. Due to their low trading prices, one can be easily deceived into underrating a big loss. For instance, a small move from $ 0.50 to $ 0.25 may be seen at first as insignificant.
However, a keener assessment will reveal that the move is a 50% loss. Therefore, if you had opened a large position, such a “small” change can translate to large losses. This level of volatility makes penny stocks highly risky.
Lack of transparency / inadequate information
Quite often, many penny stock companies are unknown to their investors, who are habitually too focused on profit-making to find out more about the companies. Such companies also tend not to have a lot of information available for scrutiny.
It is, therefore, difficult to study their past performances, including instances of involvement in legal troubles. This puts investors in a dilemma whereby, on the one hand, they are interested in investing in a company, but on the other hand, they know so little about it.
Low trading volume
As mentioned earlier, many penny stocks are traded over-the-counter as opposed to standard stocks, which are traded in big stock markets. This can create problems when you want to sell them, but there are not enough buyers in the market.
You may therefore have to wait for a long time before getting your money, which may deny you an opportunity to invest in other more profitable assets.
You can get profitable investment opportunities from penny stocks. However, their risk factor is relatively high, and you should be very keen on the financial position of a company before committing your money to it.