When it comes to penny stocks, an investor may come across several definitions from different sources. According to the United States Securities and Exchange Commission, the term “penny stock” is loosely defined to refer to a stock that trades for under $5 per share. On the other hand, under Fidelity, they are usually referred to as micro-cap stocks which are traded at less than $3. There are even several groups of investors who consider any stock trading at less than $1 or those which are traded Over the counter as penny stocks. Stocks that are traded over the counter are usually listed on a Pink Sheet. Companies listed on a pink sheet are usually not traded elsewhere on major exchanges such as the NYSE or NASDAQ.
There are two main features that are responsible for attracting investors towards penny stocks. These are the potential for quick gains and the low stock price. The low stock price allows investors to purchase and hold a significantly larger number of shares.
Penny Stocks: Cheap But Risky
There are many features present in penny stocks which make it a valuable investment for trading. However, before moving any forward, some of the inherent risks in penny stock trading need to be discussed.
Greater potential for loss: There is a greater potential for loss associated when investing in penny stocks, as compared to investing in established companies that usually trade on larger exchanges.
Lack of reliable information: Many penny stocks lack general, reliable, and readily available information because they are not required to do so. A significant number of penny stocks are issued by newly formed companies with little to no background information or market track record. This makes it almost impossible to evaluate them.
Low liquidity: Many penny stocks are not heavily traded and thus possess low liquidity. Investors wanting to buy or sell a stock with low trading volume may not be able to do that at their preferred time or at their desired price. This makes it a costly affair for the investor.
How to Choose
Checking the Fundamentals: Investors are always advised to conduct due diligence before investing in penny stocks. After making a short-list of stocks to invest, traders and investors should always thoroughly examine the company fundamentals of each stock. This involves weighing any potential gains against any fundamental factors underlying the company, such as its cash flow, buyout potential, level of debt, and other factors. Investors should be fully aware of the reason why a particular stock is trading at its current price.
Watching for Trending industries: Penny stocks are usually found in industries that offer binary outcomes to most of their companies. Traders thus should take advantage of these binary type companies when there are favorable conditions prevailing such as when a particular commodity or industry is booming. As mentioned before, due to the current COVID-19 pandemic that the world is experiencing, investors typically go for either a company which is associated with the medicines or the treatment of the virus, or companies which are benefiting from the change in our lifestyle due to the worldwide lockdown, such as telework enablers, streaming services, and virtual workout providers
Professional Management: Ethical and experienced management which have a vested interest in the company behind the penny stock can provide investors with an increased sense of security.
Trading vs Investing in Penny Stocks
People can either trade or invest in penny stocks and there are several ways one can do this.
Trading Pump and Dump Intraday: Trading pump and dump Intraday for penny stocks can generate huge profits. This is due to the low liquidity level of penny stocks, where price moves can reach several hundred percent in a single day. Thus intraday trading, in this case, involves some technical and volume analysis.
A stock which has surged in price should almost always rise in trading volume. Trading systems and strategies used with penny stocks usually consider its low liquidity and are thus designed to maintain relatively small position sizes. Positions sizes shouldn’t be too large, because of high volatility and a small number of shares outstanding. That is how trading penny stocks intraday works:
A lot of traders have short positions and stop orders in “bad” stocks. They usually wait until those companies go bankrupt. When the price rises due to a volume spike after a small number of shares become available, the stop orders are executed. This sends the stock prices even higher and traders can use this opportunity intraday. Trading this momentum by efficiently managing risk, can earn a good single day profit from penny stocks.
Investing in several penny stocks: Investors can build portfolios with a combination of different penny stocks from different companies. This can include cheap stocks that are exchange-listed and which do not trade on the traditional exchanges. Investors can reap the profitability of this investment even if just a few of the stocks survive.
Trading penny stocks require the trader to focus on risk management and technical analysis involving charts. Investing in penny stocks requires due diligence and careful research on the part of the investor. They should not hope for any short-term profits and instead, should focus on the long-term by diversifying their portfolio with different penny stocks.
Penny stock investors are taking an increased risk with the degree of price volatility present in the penny stock market. However, this does not reduce the significant profits that can be had if one invests or trades in Penny stocks. If an individual has the required knowledge, experience, and is willing to tolerate a little risk, penny stock trading can be a great source of income with possibilities of massive gains.