What are Penny Stocks?
Penny stocks are stocks that are traded below $5 in the market. You must have held or read stories of how some people started investing in penny stocks with just a very little amount. And within some months, they achieved more than double on their investment. This could be real as it is practicable. But I don’t want you to be carried away with these success stories. Instead, I would enjoin you to first understand the rudiments of penny stocks before you dive into it. The truth is that, if you invest blindly in penny stocks and start expecting share appreciation, you may experience frustrations. People will only share their success stories. Unfortunately you can hardly find anyone telling you about the losses he suffered by investing in penny stocks. Penny stocks are like any other stocks. Investing in them can lead to gain or loss. But knowing basic things about penny stocks can enhance the level of your success investing in them. On this note, I will like to beam a searchlight on some vital aspects to penny stocks
Penny stocks usually trade below $5. This is a low price indeed. With little amount, you can buy large number of penny stocks. For example, if you have $10,000 to invest in a penny stock selling at $4 per share. You will be able to buy as much as 2,500 units assuming that the transaction costs are all inclusive in the $4. This seems good. But I want to say that share price is relative. The fact that you are buying penny stocks does not mean that they are cheap. At times a penny stock of $1 per share can be more expensive that a blue chip stock of $1000 per share. So, before you buy any penny stock, you need to ascertain whether the stock is over-prized or not. If you know how to carry out the fundamental analysis of a company, you will be able to determine whether the price of the stock is fair or not. Sometimes people invest into the future of penny stocks. You should know why you are buying a stock at a particular price. If you don’t have confidence in the management or in the future of a company, it is not advisable to buy the stocks of such company no matter how cheap it may look like. One of the myths about penny stocks is that the price will appreciate. The truth is that, there is no assurance that the price will go up.
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You can look at the price of a stock from another point of view. What has been the trend of the price of the stock? If a stock used to trade for $10 is now being sold for $4, you may need to investigate the reason for the significant fall in its price. You should not assume this as a very good investment opportunity. Of course, expert will advise you to buy low and sell high. In this case, you should be able to gather some facts which will help you believe that the stock price will bounce back. Also, fluctuation in stock prices can be a good signal that you will be able to make profits from such penny stocks. If the price of a stock remains unchanged over the years, you may not bother to invest in such penny stocks. But if the company has just launched new products or there is a management restructuring within its system, this may lead to better performance. In this regards, one can be proactive by quickly invest in such stocks ahead of when the financial reports of the company will be released. I have seen some penny stocks like this appreciating in prices more than 100% within a year.
Age of the company
Why is the age of the company relevant here? Well, most penny stocks that usually perform exceptionally are stocks of companies that are relatively new. If they are not new in term of years of operations, they may be new in term of the time the stocks were introduced into the capital market. If a new company with growth potential is just listed in the stock market, investors usually seize the opportunity by buying the stock, thereby investing into the future of the company. On the other hand, if a penny stock has remained a penny stock for years, you can use the past to project the future. Nevertheless, if the stock prices fluctuate, you can take advantage of such fluctuation. Investors that are very good at technical analysis know how to predict share price by studying the charts and trends. If the price of a penny stock behaves in a predictable manner over the years, one may decide to buy such penny stock when the price is relatively low and later sell it when the price goes up.
Assessing the risk involved in investing in Penny stocks
One cannot truly assess the risk involved in investing in penny stocks without talking about their features. Few of the features enumerated below can pose as risks and can be an opportunities at the same time.
- Volatility: One of those factors you need to consider before investing in penny stocks is your attitude to risks. Penny stocks are good for risk takers. If you are not a risk taker, I may suggest that you stay away from such stocks. The reason is that the price of a penny stock can easily drop by more than 50% within a short period of time. In the same vein, the price can swing upward astronomically. In most cases, people tend to be attracted to the positive aspect. But as an investor, you need to prepare for whatever may the outcome of your investment whether positive or negative. Under favourable situations, a penny stock can grow from $1 to $4 within a short period. This represents 300% gain. That is amazing performance. But let’s look at the other way round. If you buy a penny stock at $4 and the price drops to $1; that will be 300% loss. So, before you rush into buying penny stocks, you need to ask yourself if you are ready to take such risk. Investing in penny stocks is like a game, the higher the risk, the higher the likely returns.
- Ease of Conversion to Cash: Before you buy any stock, you should have the assurance that you will be able to sell it any time there is a need for that. Liquidity is very critical in stock investing. In fact, some people prefer investing in shares to real estate because of liquidity. However, you need to note that it is not all stocks that enjoy liquidity. How would you know whether a particular stock is liquid or not. You will know this by focusing on two things namely the daily trading volume of the stock and the number of deals that makes the volume. Volume alone is not enough because a single institutional investor may be responsible for a high trading volume of a stock. But the number of deals will let you know whether the stock enjoys patronage from other investors or not. But what is common with some penny stocks is lack of liquidity. When a stock is not liquid, you will find it difficult to take position supposing you want to cash in your gain. Also, if the price is trending downward, you may not be able to cut your loss on time.
- Absence of Chart/Trend: Before you can carry out the technical analysis of any stock, you need chart and the trend showing the history of the stock. Some of the penny stocks are usually stocks that have just been listed through initial public offer. So, they may not have history which can help you predict what will be the behavioural pattern of the stock price. Therefore, investing in penny stocks can be described as bling investing. It is like closing your eyes to make investment decision without much clue about what the outcome of the decision may be.
- Insufficient information: Unlike blue chip companies, some of the penny stocks you find around us don’t file information with Securities and Exchange Commission. So, the information which may help potential investors make informed decision may not be publicly available. So, information is like a guess say which at times can be correct or not. Nothing can be so devastating like basing your investment decision on wrong information. Having acknowledged that you may not have enough information about micro-cap companies, it is paramount that you invest in the companies with good management. Also, the products or services a company sells/renders is very crucial. We are in a changing environment. You need to assess the technology may have on the company. Any company that cannot ride on the wings of technology may not be a penny stock to buy.
- Listing requirements: We know that stocks on Nasdaq and New York Stock Exchange for examples have to comply with minimum listing requirements in order to remain listed on the Exchange. This is not so with micro-cap stocks. When standard is lacking, anything goes.
- Susceptible to scamming: Penny stocks are usually the target of most of the stock scammers. The fact that the prices of penny stocks are generally low makes it to be very attractive to many people. This makes it easy for scammers to always get people into their nets. What do the scammers do per se? They can send you different offers to your mail box. But I will say that if an offer looks too good, it can be a scam. How would you know whether an offer is good? That is why you need to educate yourself on the subject of investing. If you know how to analyse stocks by yourself, you will be able to identify good offers from bad ones. It should not surprise you that some micro-cap companies do engage in many activities that can drive the price of their stocks. Such activities may include road shows, sponsor posts, press release and so on. It is not every time you see somebody speaking on television about a particular penny stock that you should act on whatever he is saying. It is possible that the person is hired to speak positive things about a company so as to attract investors. Also, penny stocks are prone to price manipulation strategy known as pump and dump. Pump and dump occurs when institutional investors create hypes around a particular stock thereby causing its price to go up. When the price attains a reasonable level, they therefore offload the stocks. Thereafter, the price of such stock begins to tumble.
Penny Stocks Investment Strategies
When it comes to penny stocks investing, you need to develop your own investment strategy. Before I start talking about strategies, I like to say that penny stocks are not for everybody. In my article entitled “Investing in Stocks: Beginner’s Guide on How to Buy Stocks”, I mentioned that you need to define your goal. Asking yourself “why do you want to invest in stocks” will influence the kind of stocks to buy. For example, if you are a retiree, what you need are dividend paying stocks that can guarantee you income. Having said that penny stocks are very risky, you won’t expect a retiree to put his money into penny stocks. On the other hand, a young man with good job possibly trying to save towards starting a business in the future can afford to play game with his money. He attitude towards risks will be higher than that of a retiree. If he loses his investment, he has something to fall back on. So, if you feel that you are ready to take the risk involved in investing in penny stocks, the next thing is for you to define your strategy. Mainly there are two main strategies of investing in penny stocks. You can either be a day trader or a long term investor. Let me explain the two below:
Penny Stocks Day Trader: Being a penny stock day trader does not necessarily means that you need to be trading on a daily basis. It means that your objective for buying penny stocks is to buy at a good price, hold the stock for a short term and then sell off at a profit. In order to achieve this, it will require that you are very active in the market looking for opportunities in the market on almost a daily basis. You need to be up to date about market news and information which may drive the price of the stock in which you have interest either up and down. Penny stock day trader will be more interested in technical analysis of a stock than in fundamental analysis. Also, this will require that you invest in stocks that trade in volumes. This will give you the opportunity to sell any time there is need for you to sell. If you don’t have time to monitor stock prices, you can’t be a penny stock day trader. Also, if you invest in too many penny stocks at a time, it may be very tasking monitoring all the stocks.
Penny Stocks Investor: The main difference between a penny stocks trader and a penny stocks investor is the time range, Penny stock day traders usually invest for a very short term while penny stock investors invest for long term. Because of this difference in the two strategies, it is important that penny stock investors buy stocks in micro-cap companies with very strong fundamentals. Even, if there is any temporary drop in the stock price, you can be assured that the price will reverse itself. But if you invest on stocks based on news without any strong fundamental, just little negative information can crash the stock price. Nevertheless, since most penny stocks are either new companies, there is no guarantee that they will succeed.
In conclusion, everything about life is about taking a risk. If you are not ready to take the risk, then you should be ready to forgo the returns too. At times, it can be more risky not to take any risk at all. I want you to know that penny stocks can give you high return. But this will only be possible if you select the right penny stocks. Therefore, if you are taking the risk, let it be a calculated risk.
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Because of the volatility risk involved in penny stocks investing, I like to mention that it is better to start small especially if you are a beginner. Try to test the water first before you dive in. It can be painful to see your hard earned income gone to the drain. You need experience and skill more than you need money. If you don’t have the experience yet, it is better you give yourself time. Invest little and slowly. Try to understand what works and what doesn’t work. Even if you are fortunate to get it right in your first attempt, that may not mean that you have fully understood the market. It is when you have tried a particular strategy for three or four times and achieved the same result that you can beat your chest that the strategy works. Even with that, you will still realise that there will be a time that the strategy may fail you. That is stock market for you. You may not win at all times. But as a good penny stocks investor or penny stocks day trader, your wins should exceed your losses.
Another warning I want to sound is that, it is not advisable to borrow to invest in penny stocks. Investing in penny stocks is risky on its own. Taking a loan to invest in penny stocks is carries additional risk. If any one should advise you correctly, he will tell you that you should not invest the money you cannot afford to lose even if it is your own personal savings. You don’t need to put yourself under unnecessary pressure. You understand that it is very easy to go into debt. But it can be very difficult getting out of debts. You should also consider the effects the debt may have on your credit score.
Furthermore, I like to enjoin you not to fall in love with any stock. Naturally, love makes one to overlook certain weaknesses in another person. Love can make you to stay with someone during hard times. Unfortunately, this may not apply to investing. If your analysis reveals that a penny stock may not be good to buy, you should not be emotional about it. You need to let it go and look for a better stock to invest in. Also, if you invested in a particular stock and the stock is not performing as expected, you should not tie down your money on it except there is a very strong indication that the situation will improve. You should be willing to sell the stock so that you can invest the proceeds in another better stock.