What Are Penny Stocks?
Penny stocks provide an opportunity for investors to purchase shares of a company for a low cost. They are securities that are traded for less than $5 a share, and the price often fluctuates significantly. Investment in penny stocks is considered to be a high-risk strategy, given the lack of liquidity and the relatively low available information on penny stocks. Despite their risk, penny stocks have their fair share of followers who believe in their high potential to yield high returns or who see them as a way to gain greater portfolio diversification.
Understanding Penny Stocks
Penny stocks are typically shares of small companies traded on the over-the-counter (OTC) market. The OTC market includes broker-dealers trading on behalf of their own clients as well as a network of market makers who trade stocks with one another, often through an Electronic Communication Network (ECN). Penny stocks are typically stocks of companies with a small market capitalization (generally under $500 million). These companies may lack financial stability, a consistent track record of revenue, and the established history of larger, more established organizations.
The high level of risk associated with penny stocks is due primarily to low liquidity. Low liquidity makes it harder to buy and sell shares at fair market prices. In addition, penny stocks may also be subject to sudden, large fluctuations in price due to news or changes in the stock’s fundamentals. Further, since penny stocks are often thinly traded and listed on the OTC market, there may be limited information available on the company’s financials or other metrics to help investors make sound decisions.
Benefits and Risks of Investing in Penny Stocks
Despite these challenges, penny stocks offer several advantages that draw investors to them.
Investment Cost: One of the foremost advantages of penny stocks is the low initial investment cost. Penny stocks are affordable to most individual investors, as they generally range from a few cents to $5 per share. This low cost allows investors to purchase a larger number of shares, thereby increasing the potential for higher returns.
High Growth Potential: Because penny stocks are issued by small companies, their share prices can increase rapidly with positive news about the company or industry. Having the potential for large gains is a major draw for penny stocks in comparison to other investments.
Diversification: Penny stocks can be used as a tool to diversify an existing portfolio. Investing in a variety of penny stocks can help manage risk while also potentially increasing returns. However, this diversification should also be done with caution to limit risk.
Risks of Investing in Penny Stocks
Investing in penny stocks can be both profitable and risky. The risk of penny stocks is due primarily to their lack of liquidity, potential for fraud and susceptibility to market manipulation.
Low Liquidity: Penny stocks typically trade much less than larger stocks, so it may be difficult to buy or sell shares at fair prices. This can often impede an investor’s ability to realize gains when desired.
Fraud Risk: Because penny stocks generally have less information available and lack credible financial reporting, it is difficult for investors to assess their true value. Fraudulent companies may seek to utilize the penny stock market in order to lure investors with the promise of high returns on investments that have little or no value.
Market Manipulation: Penny stocks may also be subject to market manipulation by traders seeking to push up the stock price in order to increase returns. This can create sudden gains or losses in share prices, which can be difficult to predict or protect against.
Investing Strategies for Penny Stocks
Despite the risk associated with penny stocks, there are several strategies that investors can use to minimize the risk of investing in them.
Research: Conducting thorough research and due diligence is one of the best ways to minimize risk when investing in penny stock. Investors should take the time to analyze the financials, management, industry trends and other factors of a penny stock before investing.
Set Limits: It is important for investors to set limits not only on the amount of money they invest but also on the number of shares purchased. This helps to limit overexposure to any one stock.
Monitor Trades: Carefully monitoring trades can help to protect against losses due to market manipulation or fraud.
Penny stocks can offer high returns and lower entry costs, but they also come with significant risk. Understanding the risks associated with penny stocks and the strategies to minimize this risk can help investors build a successful portfolio in the penny stock market.