Are penny stocks high risk?

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Are penny stocks high risk?

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 Are penny stocks high risk?
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Summary

  • Stocks available at a very low price, i.e, under 1 dollar and low market cap are termed penny stocks. In some stock exchanges, stocks below $5 are also considered as penny stocks.
  • Penny stocks can give high returns in the short term but are always associated with high risk.
  • Due to the low price and the lesser number of shares available for trade, they are easy targets for price manipulations.
  • There are stories of penny stocks becoming large companies and give multibagger returns, but such incidents are rare and should be taken as exceptions.
  • A penny stock could become a turnaround story only when they deliver consistent performance over the years.

Penny stocks, as the name suggests, are small cap or micro-cap stocks that trade under one dollar. Usually, many such penny stocks are embroiled in losses. Due to their low float, many operators target such stocks to pump and dump.

Good read: Can you count on penny stocks to make money?

People get attracted to penny stocks due to high fluctuation in prices. Plus, with relatively lower money, a huge number of these shares could be brought. The logic could be understood easily with an example- suppose some ABC company is listed on the ASX and trades at a price of AU$0.005 per share. Now anyone with AU$1,000 could buy around 200,000 shares of this hypothetical firm.

These AU$1,000 could get only 20 shares of BHP Group (ASX:BHP) and only 8 shares of RIO Tinto (ASX:RIO) at their current market price. Many novice traders get drawn to low priced shares as buying large number of shares lures them. Many fail to understand that it’s not about the stock price but about the stock valuation and business prospects that drive the stock price and not the other way around.  

Read More: Three tips to withstand market’s volatility

Well, the probability of becoming a millionaire by investing in penny stocks cannot be ruled out completely, but it’s a rare occurrence. Many experienced investors will validate that companies seldom turn around.

Thus, when such businesses don’t turn around, investors end up holding large number of shares of illiquid penny shares, most of the time, people get stuck in the stocks and not even make an exit from them as there are very few potential buyers of such penny stocks.

So how does it begin, and why it is considered a trap?

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Penny stocks are extremely volatile, attracting investors willing to take high risk in return for high profits in the short term. Sometimes, many good companies trade in the range of penny stocks when there is market meltdown. Often times we have seen that some particular sector takes the plunge, like crude oil sector in March of 2020 and stocks related to such sectors plummet.

Also read: Keen on penny stocks? Here are five trading tips

In a typical case, some investors or group of investors will pick a penny stock to invest in for a short term. As the sudden flow of money hits the counter, the share price of the penny stock starts rising. Since it is done by one or multiple people, they keep on buying shares at regular intervals to keep the share price running high. Gradually, the stock will come into the view of investors who are eagerly waiting to get multi-bagger return in a short period. They will now start placing the order to buy shares. A penny stock has a very low market cap, and the float or the number of shares are also low, so under times of high volatility be it up-surge or down moves, liquidity tends to dry up further due to greed or fear.

When such penny stocks become one of the hot stocks and investors and traders ‘queue up’ to buy such shares in the hope to get the buy order executed. At times, the so-called operators who hold huge lots of such penny stocks will soon start selling or dumping their holdings as there will be a lot of buy orders pending. They will sell in small quantities so that it will go unnoticed by retailers. The constant selling and buying will drive the prices higher, and at one stage, the operators will leave the counter leaving small-time investors trapped. At this stage, with limited new buy orders filling in the prices start to drop, triggering panic selling. It is very difficult to get rid of such shares.

Read More: Pondering over penny stocks? Check out these five golden investing hacks

Low liquidity and lack of consistency in performance

The number of shares of a penny stock is limited and is lower in quantity as compared to small, mid or large-cap companies. A 10 cent or 20 cent stock will move less in monetary value, but in percentage, it will be large. If a 50-cent stock moves 5 cents in a day, it will be a 10% rally. Since the price is too low, anyone with a deep pocket could manipulate the counter. Also, most of the time, it is difficult to buy in an uptrend and sell during the downtrend.

Read here: Five Lithium penny stocks that are packing a punch

Some people buy and hold penny stocks in the hope of turning them into a multi-bagger investment and with the hope of business to turnaround and sooner or later and would grow into a blue-chip company over the years. Turnarounds do occur in the stock market and are not something unheard of. But it is a rare incident, and out of hundreds only a few of them actually make it to the big league.

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Read here: Five ASX penny stocks that are delivering high returns

But investors need to watch the performance of a particular stock over a considerable period of time and make an analysis about the business model and performance of the company and should made a decision based on the fundamentals of the company and not just low share price.  

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