Five things to keep in mind while trading penny stocks

Highlights

• Buying penny stocks in a hope of a windfall profit is a high-risk bet and only a very few bets prove right.
• One could also practice trading these stocks on a virtual platform first to hone their skills before putting their money on the line.
• Investors need to make sure that the penny stock of their interest is liquid enough to absorb their volume.

The penny stock space might seem lucrative, especially looking at those multi-bagger returns in hindsight. Penny stocks often trade at less than a dollar value and more often than not, are junk stocks, which means the underlying business is almost non-existent or the company could be in financial distress.

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Buying these stocks in a hope of a turnaround is a high-risk bet and only a very few bets prove right. In most other cases, the investment goes to the dogs. However, if you are keen to trade in this high-risk and high-reward space, then we have some tips for you that could come handy while managing your risk.

Read more: Why Is Investing In Penny Stocks Sometimes Important - SPT, MMM, ROO

1. Keep liquidity in check

 Because of its inherent high-risk nature, a lot of big players such as institutional investors or fund houses tend to steer clear from this space, leading to a dried-up volume. Investors need to make sure that the penny stock of their interest is liquid enough to absorb their volume.

A relatively higher volume of an individual than what a stock receives normally can influence its stock price, leading to an increased impact cost. Therefore, it’s sometimes better to avoid penny stocks with extremely low liquidity.

2. Position sizing

A trader/investor needs to understand his risk well in advance to work out a plan on their position’s size. The number of shares to buy should be co-related with the portfolio size and the risk one is willing to take.

Having a quantitative measure of risk helps to define an optimal quantity of shares to be bought in a single stock. Generally, it is not recommended to allocate more than 10% of the portfolio to penny stocks.   

3. Stay cautious of traps

Most of the time, these penny stocks are used as traps to lure investors and rip them off their money. This is done through a few parties buying fewer liquid shares aggressively to artificially inflate its price.

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This rally is then noticed by retail investors/traders who then dive into, these shares and soon after their participation, the big hands get out with their profits, leaving investors with penny stocks at an expensive price. This is also known as a “pump-and-dump” scam.

4. Avoid FOMO (fear of missing out)

Avoiding FOMO would prove to be beneficial not just in the penny stocks space, but in the entire financial market. When a trader/investor starts to chase a rallying stock, they often get in at an expensive price. The underlying emotion of fear of missing out on an opportunity plays here.

Penny stocks can take very sharp moves in the blink of an eye, therefore buying at a wrong price during a rally could soon get a trader/investor in trouble. They should always remember there are ample amount of opportunities in the market, and it’s better to search for a new one than to buy a stock that has already run up quite a bit during a rally.

5. Be nimble and agile

A lethargic behaviour in the stock market won’t help you to sustain for long, especially in penny stocks. Because of high inherent volatility, you must be quick enough to book your profits at the first sign of reversal.

Being quick and nimble also apply to cut your losses short. As important as it is to protect profits, it is equally important to minimise your losses. This will help you to sustain a losing streak.

Bottom line

Trading in penny stocks requires a different skillset and a trader/investor needs to be quick enough to handle the volatility of these stocks. Also, all kinds of risk measures such as optimal portfolio allocation, pre-defining the maximum loss, protecting profits, etc., must not be ignored.

One could also practice trading these stocks on a virtual platform first to hone their skills, before putting their money on the line.              

Read more: 6 Questions You Need to Ask Before Investing in Penny Stocks