Penny stocks refer to a small company’s stock that typically trades for less than $5 per share. Although some of them trade on large exchanges such as Nasdaq and the NYSE, many trade via over the counter (OTC) operations.
Normally associated with small or growing companies, with limited cash and resources, penny stocks trade infrequently, which translates into lack of liquidity. While seen by many investors as a great growth and profitability opportunity.
In general terms, liquidity means the speed and ease with which an investor can dispose of an asset. In the case of stocks, it measures their ability to sell bonds without making losses due to the need to sell them.
If there is a fundamental difference between regular and penny stocks it is the risk level
Penny stocks are evaluated mainly by their stock prices while regular stocks are based on a company’s market capitalization. Many regular stocks are blue chips that can give investors additional safety in volatile markets, steady or rising dividends and growth perspectives.
Take note, blue chip stocks: are typically from nationally recognized, well-established and financially sound companies that sell widely accepted products and services, with a long record of stable and reliable growth.
Supply and Demand
The big issue is that liquidity is totally tied to the law of supply and demand.
If there are many buyers interested in your title, its value goes up and the selling price becomes more attractive, allowing you to sell it faster.
However, when the interest is scarce and the need to get rid of the paper is greater than the buyer’s purchase, the seller needs to give up part of the profit and lower the price until he finds someone willing to pay it.
Precisely the case that many penny stocks usually meet.
The next threat – the distrust of the company
Often these small companies are so deep in debt and/or have such low credibility that the potential of the stock cannot be measured. The risk then, for most, is not justified.
A few visionaries, though, see a real possibility of return and invest in the company. Sometimes it works, but it is not an easy investment. On the contrary, it demands a high level of investor experience and a higher risk tolerance.
Where some investors see risks, others see opportunity
Lack of liquidity, serious price fluctuations, fraud potential, volatility. Why do some people still invest in penny stocks?
The higher level of volatility results in a higher potential for reward. Also, any movement in the stock market is generally amplified exponentially in penny stocks. So if the market goes up, penny stocks go up even more and if the market is down, then they are way down. Some investors are attracted exactly by this exciting kind of investment and the potential for above-average returns.
While there can be sizeable gains in trading penny stocks, there are also equal risks of losing a significant amount of an investment in a short period.
Considering the high risks associated with penny stocks, investors should take specific precautions, like a stop-loss order.
Stop-loss orders are instructions placed with the broker to set a price limit that, once reached, will trigger an automatic sell of the securities.
Penny stocks prospects are often exaggerated. Be careful with heavy unofficial promotions through emails, telemarketing, claims of inside information and online forums with lots of recommendations. These are signs of scams and should raise a red flag.
If you are looking to add to the aggressive portion of your portfolio, you may want to turn to this higher-risk strategy and buy penny stocks but limit them to a small part of your portfolio. Remember that knowledge is key to reaching your goals. We’ve created a series of articles covering all the basics to start, check out Stock Market Guide for the next steps and tips on Building a Profitable Stock Portfolio.