Penny Stocks: Does it Pay to Think Small?
To be a successful trader you need to be able to find and act on opportunities wherever they may arise and, whilst you may have lofty ambitions as far as the return on your investment is concerned, that doesn't always mean you'll be looking at investing in Fortune 500 companies that are already world beaters. This is where so called "penny stocks" come in.
What Are They?
"Penny stocks" is a term used generally in reference to low priced speculative securities for small companies (defined here as a those with a market capitalization of less than $500 million). Usually these are new ventures that, at present, lack a great deal of market penetration. As a result these stocks are not to be found in the typical markets that would normally provide the bulk of an investor's portfolio, such as NASDAQ, AMEX and the NYSE, for instance.
Instead you will find "penny stocks" available on "over the counter" markets, such as the pink sheets and OCTBB. As they are not available on the major markets, the sales of such stocks are subject to less stringent standards and regulations.
Furthermore, as very few people would be willing to pay for the information, these companies are not usually covered by stock market analysts. This can mean finding accurate data on prices and other information you'd usually look at before investing is much harder when dealing with a penny stocks than it would be with a blue chip company.
On top of this, as these stocks are only traded infrequently there is a substantial possibility that, once you purchase the stock, you won't be able to find a buyer for it!
High Risk, High Reward
So, with all of those rather daunting facts in mind, what are the advantages, if any, of trading in penny stocks? Well, put simply, penny stocks are a classic example of risk to reward ratio. For the reasons outlined above they undoubtedly carry with them a high risk, and, on the flip side of that same coin, they carry the potential to bring, high levels of profit quickly.
This is because, due to the low price of the stock, even what would normally be considered a small movement in the market, may quickly lead to gains of hundreds of percent of your initial investment.
Of course, this volatility works both ways, and with these sorts of businesses, folding is usually a real possibility. Therefore, as these companies are not obligated to prove financial health, it really is best to got through a trusted broker, follow advice and do a decent amount of independent research into the company.
Market Manipulation
Finally, owing to the fact the trading in these markets is less frequent, there is the potential for unscrupulous traders to use this relative inactivity to artificially manipulate prices by buying up large amounts of a stock themselves.
This is done to tempt others into buying. However, when it comes time for these investors to sell, they may find that the demand they perceived for the stock was never really there, and will need to lower their ask price to the point of a loss, just to find a buyer.
The high risk/ high reward gamble provided by penny stocks can afford them a place in the portfolio of experienced traders, offset by the stocks of big name companies in much less volatile markets.
For the new investor, penny stocks should be approached cautiously and the help of a reputable brokerage firm enlisted. Even if you only want to dabble within the world of penny stocks, remember to lessen risk by diversifying. Don't invest it all on one company.
Will Kerr writes on a wide range of trading and investment related topics for Elite Money where you can read more of his thoughts.
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