The term penny stocks refer to any stock that its value is less than a dollar.
Their value is usually in a penny.
Often the assumption is that these penny stocks are more risky investment proposition.
They says it also entails the greater possibility of loss in case the stock value slips.
However, the questions that you must understand are what are penny stocks and how you can trade them.
Only then, you can decide whether investing in penny stocks would be worthwhile and yield the kind of gains that you would be anticipating.
What Are Penny Stocks?
Here is the simplest definition for penny stocks:
Penny stocks are essentially low-value stocks that trade out of the main exchanges.
Often termed as high risk and low liquidity counters, the SEC terms all stocks with a share value less than $5 as penny stocks.
This is in accordance with the provisions of the US Securities Exchange Commission.
Moreover, arriving at a fair price is also a difficult proposition for many penny stocks.
Given all these factors, many times investing in penny stocks is speculative.
So when you commit your money in penny stocks, you also need to know that you lose the whole money.
Or, at least a part of it, depending on your investment margins.
However, there is no hard and fast rule.
Most times, the kind of value that the stock yields goes on to determine its core value.
This is exactly why there are some who look at $3 mark as the cut-off point.
Many others strictly use the $3 mark to terms stocks that are trading at less than $1/share.
Just a study of the top three penny stocks on Nasdaq would give you a fair idea of the valuation matrix.
The Gold Standard Ventures stock is priced under $3 while Zosano Pharma’s valuation is about $2.50/share.
Mobile Iron, another top trading penny stock trades under $5.
Most times you would see the upside and the downside is dictated by news based triggers.
The reason they are called speculative is sometimes the upside or downside in the stock is dictated by promoter action, and this is a worry point.
It case of any negative promoter action, all those people who are invested in these penny stocks, end up losing most or all of the investment that they had made.
1. Creation of Penny Stocks
In your quest to understand what penny stocks are exactly, it is also important to understand how these get created.
Well like any other stock, they all come into being through an initial public offer or an IPO.
These penny stocks typically trade over the counter instead of listing on exchanges.
Most times, small businesses and micro enterprises issue these counters to address their funding problems or requirements.
Start-ups desperately in need of raising capital for expansion look at this way of fundraising as the most cost effective alternative.
Despite the rather long and voluminous paperwork involved, they ensure a decidedly higher amount of fundraising.
Many investors with significantly higher risk appetite begin investing in penny stocks once they start trading in the secondary market.
One of the reasons why a significantly larger number of these counters trade in OTC window is because the SEC has rather stringent norms for larger exchanges.
Inevitably, these penny stocks are unable to conform to these guidelines.
The authorities issuing these stocks must take care that they strive to continually help them gain value and get a higher value.
Moreover, even penny stock counters need to furnish financial statement publicly at regular intervals.
In many ways, this is the way that average investors without access to inside information can gauge the pace of progress that is being observed in these counters.
This is that crucial information that allows investors to take a call on the stock and exit if they perceive a potential downward spiral.
Penny stocks do trade in after hours trading.
However, the fact is they are so illiquid (thin).
Additionally, there is so little interest in it that often it becomes difficult to sell these if the price increase is too sharp in these counters.
The inaccurate pricing parameter often results in these counters noticing unusual spikes of as much as even 2000% gains in a given month.
Especially in after hours trading, where the volatility is much higher, there is pronounced and often unreasonable price surge.
2. The SEC Rules That Guide Penny Stocks
That brings us to the next point that what are these stringent SEC Rules that guide the penny stocks?
Well at the very behest, you must understand that these rules are designed with the whole idea of ensuring investor protection.
They are to make sure that unsuspecting investors do not become a victim of shrewd promoters keen to make some extra profit.
– Sales Deed:
In an effort to rein in manipulative and fraudulent measures involving the sale of the penny stocks, the US SEC makes it mandatory for brokers to approve the transaction that an investor undertakes.
The customer must also give a written consent for the deal to the dealer.
Most times, the dealer does an appropriate background check in terms of the investor’s risk exposure the limit as well as the stock’s viability as a potential money making proposition.
They are very important when dealing with penny stocks.
The broker has to give a standard disclosure to the customer who might be investing in penny stocks.
The idea is to make the investor aware of the potential risk associated with the stock, the possible customer rights ad penny-stock related norms that might be handy eventually.
Investors on their part need to read these disclosures carefully before committing cash.
The broker must also furnish proper quotation related disclosures to the customer.
This normally has the current value of the stock at which the transaction was undertaken.
That apart the compensation disclosure is also very important if you are investing in penny stocks.
Once the customer knows the exact money that the broker is making from the deal, they are in a much better position to decide whether the broker has any selfish motive in pushing the deal down their throat.
– Disclosing Monthly Statements:
Monthly statements are also an important precondition in maintaining the transparency of the penny stocks related transactions.
Pretty much like a bank statement, they have all details including the recent price moves in the penny stock that is being considered.
It is also a key tool to keep track of the market value of the stock.
The intervals at which these statements are made available are also an important consideration for the US Securities Exchange Commission.
You must understand that all these stringent measures with regards to investing in penny stocks are crucial to maintain the overall transparency in the transaction and safeguarding investor interest.
3. How to Trade Penny Stocks?
That said, it is quite apparent, that trading in penny stocks is rather tricky.
You can’t just buy them the way you would invest in blue chips or for even some of the large midcaps.
The question then is how to trade penny stocks?
Well, along with an understanding of the stock markets and deep insight into the day to day trading dynamics, it is extremely important that you set an investment target and stay within the construct of that goal.
This alone will make sure that your risk exposure is never more than what you are prepared for.
That said here is an easy guide towards how to trade penny stocks:
Research Is Important: Whether you are trading in midcaps, large caps or penny stocks, research remains the backbone of a strong investment strategy.
Before you invest even a penny towards penny stocks, you have to be sure about the stocks that you are planning to invest in.
The lack of research can be particularly problematic in the case of penny stocks.
You have to understand that unlike stocks that are listed in the secondary market, the financial results of these counters are not scrutinized by the SEC.
Therefore, you should be very sure about the fundamentals of the company before you decide to invest a single penny.
– Illiquid (Thin) Counters:
Penny stocks by the very nature of it are rather illiquid in nature.
You have to understand that if you buy a really large sum, you also need to find a suitable buyer.
Not getting one can put you in a rather difficult position.
Just to sell the stocks you might have to even lower the stock price and might have to even book losses to get even.
– Online Brokerage Account:
This is an absolute necessity if you want to trade in the market.
Having an online account will make sure that access to your stocks is much simpler, there is greater accountability, and the relative amount of money that you pay as fees or brokerage commission is much lesser.
Most brokerages do not just provide you access to trade in penny stocks.
However, at the same time, they also help you analyze different types of historic charts and technical trends to make a more informed and insightful choice as a whole.
The core idea is to book profit.
– Make the Right Choice:
When you are buying or trading in a penny stock, it becomes very important to make the right choice.
So, first of all, you need to spot the risky counters in the market and eliminate them.
It is always better if you are investing in a penny stock that is traded on a regular exchange and not just over the counter.
The disclosure for Over the counter stocks is quite limited and does not ensure a lot of transparency.
As a result, it means that you need to be extra careful about the core fundamentals of the company when you are investing in these stocks.
Avoid buying stocks of delisted companies or companies which might be at the brink of bankruptcy.
Don’t buy on the basis of what the promoters have to say.
It is important that you pay sufficient attention to core operational matrix, debt equity ratio and other such indicators that ensure its genuineness.
Even if you are deciding on an established market player, it is crucial that you do your due diligence.
An otherwise great stock might become a risky buy if production stopped suddenly or even demand cycle started peaking out.
– Don’t Believe in Market Buzz:
How do you trade in penny stocks?
In case your answer is anywhere close to relying on market rumor or going by your neighbor’s opinion, it is time to undertake a course correction.
When you are investing in penny stocks, it is never wise to go by the market buzz.
You have to make sure that you do a thorough research on every stock that you might consider buying even remotely.
– Don’t act on any impulse:
If you have received an email alert praising the great economic sense in investing in a specific counter, think again.
If required, check the disclosures and promoters of the company.
It is never wise to blindly believe in any strategy to pump up stock value.
Often we have seen that many shrewd business owners, try and pump up stock value by propagating false news about a particular share.
When the share prices have risen unusually high, the promoters coolly sell the shares to unsuspecting investors at a terribly inflated rate.
The result is gullible investors get saddled with inflated shares which have no value at all and the promoters escape after pocketing the neat profit.
– Volumes Are Important Indicators:
Investing in penny stocks can be profitable only when you have chosen the right counter.
The question is how you make sure about that simple fact.
Penny stocks volumes are an important indicator of a stock’s net value.
It is a good idea to stick with stocks with a minimum 100,000 shares traded volume on a given day.
For example, consider a particular stock trades below 100,000 shares a day and its price is below 50 pence a share.
Therefore, it is never a good idea to bet on that counter, in spite of the glorious tales that you might hear about the company’s fundamentals.
Moreover, volumes are extremely dependable indicators in the face of volatility.
You must be very sure that penny stocks are extremely volatile and in that situation volumes extremely trustworthy foot soldiers.
Only volumes alone can defy the kind of propaganda that management might want to influence with.
More or less volumes help you identify how authentic a penny stock is, and whether it would make sense to invest in the stock despite the extremely low share value.
If you are at a loss and unable to lay hands on any other fundamental factor, volumes can go a long way in helping you make a choice.
– Avoid Trading Large Quantities:
Did you ever hear of the old saying, ‘greed is bad’ and perhaps nowhere else is this fact better highlighted than investing in penny stocks.
However promising a stock entity might appear, it is never wise to invest in large quantities in a penny stock.
Caution is the name of the game.
It is always a good idea to trade less than 10-15% of the daily volumes that gets traded on a specific stock.
That too, it is good to stick with stocks that have a presence in the relatively larger exchanges.
Moreover, whatever amount you might be investing in penny stocks, never avoid holding these counters for very long.
However exciting the story might seems, look at disposing of these penny stocks after a reasonable time.
This will ensure that in the tryst for longer or bigger gains, you do not end up losing even the principal amount.
Not just that, you might be saddled with a truckload of useless stocks that you are unable to part with.
Additionally, limiting the stock amount would limit the share amount that you might have to get rid of eventually.
4. Why Are Penny Stocks Risky?
Investing in Penny Stocks can be risky proposition most of the times.
The reality is investing in these stocks can inevitably lead to more trouble than gain.
However boring your conventional investment ideas might appear, they are at least safe options.
On the contrary, just by taking a position in these stocks, you are exposing yourself to immense risk.
– Risk Of Bankruptcy:
You would notice, often many of the small companies issue stocks to raise some quick money and the penny stocks get created.
Often all that these promoters are interested in raising the stock price, sell off the stocks and disappear with the amount that they make eventually.
But you must understand that the basis of most of these penny stocks is essentially in its troubled financials.
So in any case, the financial state of a penny stock promoter is generally doubtful.
Also it cannot be believed until you are personally aware of the company’s fundamentals.
– Potential Buyout:
Given the troubled financial condition of many of the penny stock companies, it becomes very important to watch out for buyouts.
I am sure you remember about the merger of the American Airlines and think you were a penny stockholder in that deal, what would be the prospect of your holding, how much would you lose and how much would you be able to recover?
That is a concern that will always remain a worry for a penny stockholder.
While sometimes it might become a profitable opportunity but there is an equal risk of it resulting in significant large losses as well.
The cost of acquisition and business fundamentals could also result in entire value erosion, and you might have to with it for a rather long time before your investment yields any value whatsoever in the long run.
5. Penny Stock Scams
There are many ways that penny stock scams are propagated.
Well here is a quick lowdown on some of the common strategies that are employed to create value in fake entities:
– Pump Up Share Value & Dump Them:
This is perhaps the most common type of penny stock scam.
The stock fundamentals and the overall valuations keep getting promoted, and as a result, the share price keeps rising.
There are instances when the price rises as much as 2000%.
When the promoters or the scamsters stop, the share on its own starts diving down to fair value level and those who were investing in the penny stock suffer grave losses.
– Using Social Media Promotion:
Here the product is used to push up the value of penny stock that provides the product.
The social media suddenly begins to overflow with promotional content and unusually high fan following from all across the world.
Such is the state of following that you might be convinced that it is a great product that is on offer and might start investing in the stock believing in the fake fundamentals.
Once the motto is achieved, those behind the promotion withdraw, and unsuspecting investors get into huge losses.
– Exaggerated & Bloated Financials:
Disclosure norms, for many penny stocks that get traded over the counter as against a proper exchange, are not very strict.
In order to attract more buyers, companies often issue fake financial statement with exaggerated growth numbers.
While there have been instances of this kind of fake accounting even in established blue chips, but that’s very rare.
In contrast, for penny stocks, it is almost like child’s play, and there are innumerable instances of this kind of fake accounting.
Many gullible and unsuspecting traders take these on face value and suffer severe losses eventually.
First, make sure to understand the basics of what are penny stocks.
Then, it is very important that you trade penny stocks with a lot of care and concern.
The core policy on any training about how to trade penny stocks should be:
- Paying attention to business fundamentals
- Stress of disclosures
After all, investing in penny stocks is all about achieving the fine balance between risk and profit.
The ultimate gain is in keeping the investor wealth intact and preserving the value of your net investment.
Therefore, investing in penny stocks without due diligence and the right kind of research is a big no under all conditions.