Money — 1 month ago

What are Penny Stocks and How Do Penny Stocks Work?

by Kelly B.

Penny Stocks, What are Penny Stocks

Penny Stocks Explained

Penny stocks are those stocks which are priced very low, about $5 or less. These stocks are highly risky to invest in but sometimes have the potential of turning a small investment into a huge fortune. Most penny stocks trade are over the counter (OTC) transactions and only a very few trades on larger exchanges.

Earlier penny stocks were considered as stocks which traded below $1 but the U.S. Securities and Exchange Commission (SEC) raised the bar to $5. These stock usually belong to small businesses and do not frequently trade in the market due to lack of ready buyers and low liquidity.  Smaller companies like startups, which do not have any tangible assets, usually give out penny stocks.

Penny Stocks

How do penny stocks work?

Penny stocks trade like all other stocks but with added risks. Because of lower liquidity, infrequent trading and higher price fluctuations, these stocks are considered as risky investments. Unlike the bigger stocks for which the share prices are found in all media, penny stocks do not have any fixed platform for sharing their buying and selling prices. This makes transactions a little more complicated. Also, the fact that smaller, unproven companies issue these stocks with a very little track record, adds to the risk of dealing with these stocks.

Lower liquidity of the stocks makes it difficult to find buyers and may force you to sell at unwanted low prices. These stocks are quite susceptible to price manipulation due to lack of information on the stocks. This means someone might buy a large number of stocks and try to sell them at inflated prices using false information and fake positive records.

What are Penny Stocks

Should you invest in penny stocks?

You can invest in penny stocks keeping in mind the risks involved. An investor must be prepared to lose the money invested on these stocks and set realistic expectations when buying these stocks. In order to build your portfolio in the stock market, you must make sure that you already have a good congregation of bigger companies in your portfolio and these speculative ones are only a very small fraction of your investments. Dealing only with penny stocks will be detrimental to your portfolio as you will tend to attract lesser buyers.

Investing in penny stocks requires a considerable amount of knowledge of the trade. When buying penny stocks, try to gather as much information about the company and its management as you can. The company can only be successful if it has able management. Find out if the company has the ability to achieve what it intends to with the assets that they have.

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Study the financials of the company to see if there are any substantial debts or liabilities that the company owes. The growth record of the company is also a good indicator of its future prospects. The more transparent the disclosure provided by the company, the better. When you finally decide on investing in penny stocks, make sure to invest a very small fraction of your portfolio, preferably not more than 1% to 2%.

It is advisable to diversify instead of betting it all on the stocks of one company. Even then your total investment on your penny stock portfolio should not exceed 5% to 10% of the overall portfolio. Make sure that the stocks have adequate liquidity and trading volume so that you can find buyers when you are ready to sell. Knowing when to sell your stocks is also very important. Penny stocks are not long term investments anyway. You need to know when to sell, particularly if you have got good gains in a short period, rather than waiting for bigger gains.

To sum it up, it is just important that you make wise, well thought out decisions when it comes to dealing with penny stocks.


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