Penny stocks refer to stocks that belong to small companies. They are seen to be traded in the OTC market rather than on large exchanges. They are traded via electronic OTC Bulletin Board (OTCBB) or through privately owned OTC market groups. They lack liquidity and there is no trading floor for OTC transactions. They are considered to be highly speculative.
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WHAT IS PENNY STOCK?
According to the U.S Securities and Exchange Commission (SEC), penny stocks are defined as shares that are trading below 5 dollars. They are related to small companies and lack liquidity. The lack of liquidity denotes that the stocks are traded infrequently and there are no ready buyers available in the market place which makes it difficult for the investors to sell a stock or investors might find it difficult to find a price that accurately reflects the market. The lack of liquidity, company size, price quotes make penny stocks highly speculative.
Stocks associated with penny stocks have a poor corporate governance standard, low liquidity, high bid-ask spread, and are extremely risky. Following are some characteristics of penny stocks.
- Low Market Capitalization: Penny stocks are associated with small companies. The market capitalization of these companies ranges less than 50-100 crores which are considered below.
- Risky: Penny stocks are considered to be high-risk investments because they belong to companies that are growing and have limited capital and resources.
- Volatile: Penny stocks have high volatility levels i.e., they have the potential to generate higher returns and also a higher level of risk. The investors may earn in bulk or they may lose their whole investment on a penny stock.
- Illiquidity: Due to lack of liquidity investors find it difficult to find a counterparty i.e., investors find it difficult to sell a stock or buy it at a price that accurately reflects the market. This leads to a higher bid-ask spread.
INVESTING IN PENNY STOCKS:
Penny stocks can be considered as an investment option. Investors should be careful before investing in these stocks. These stocks are highly speculative due to high levels of volatility and low liquidity. A stop loss should be maintained by the investors to protect themselves from the downside. Investors shouldn’t invest the last portion of the portfolio in a penny stock.
As most penny stocks are traded via an over-the-counter market the liquidity on this stock is low. One shouldn’t invest in an illiquid penny stock that is trading at a low volume and should make sure there won’t be any problem when selling the stock.
Investors buy these stocks in search of a multi-bagger opportunity. The stock prices are manipulated by the stock promoters since penny stocks have a low volume and can be easily manipulated by the big market participants.
The chances of a successful trade in penny stock are dependent on the bull market and investors should invest after performing an in-depth analysis of the stock. They shouldn’t rely on any futuristic story.
Penny stocks are highly speculative. Following are the risks associated while investing in a penny stock.
- Lack of information: The companies that issue penny stocks are not covered by professional analysts. While investing it is important to have information to make a proper decision. It may be difficult to find information on the corporate performance of some penny stocks and in such case, the available information may not come from a reliable source. The lack of information makes investing highly speculative and risky.
- Lack of historical information: Penny stocks are associated with new growing companies that have limited resources and capital or companies leading to bankruptcy. These companies will generally display a poor track record or no record. The lack of historical information makes it difficult for investors to value to company’s potential.
- Low liquidity: The low liquidity levels make it difficult for investors to find a counterparty i.e., investors find it difficult to sell a stock or buy it at a price that accurately reflects the market. This leads to a higher bid-ask spread.
- Price manipulation: Since the stock trades at a low volume the chances of it being manipulated by big market participants is higher. The stocks are generally manipulated by the stock promoters. Price manipulation makes it risky for long-term investors and highly speculative.
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Penny stocks are highly risky in nature. One shouldn’t make a whole investment. Investors should not invest more than 2-3 scrips. Investors shouldn’t invest in an illiquid penny stock that is trading at a low volume and should make sure there won’t be any problem when selling the stock. Investors should perform an in-depth analysis of the stock before investing and shouldn’t rely on any futuristic story.
Author – Divyashri Kadam
About The Author – Divyashri is a Bachelor’s Degree Holder in Accounting and Finance. Also, a Certified Financial Modeling and Valuation Analyst (FMVA). She is enthusiastic to learn more about financial markets, financial analysis, and anything relating to stocks.