Why should investors keep penny stocks on their radar?

Highlights

  • Penny Stocks refer to the stocks or shares issued by a miniature company trading at less than AU$5.00 per share.
  • Penny stocks are sold and purchased through over-the-counter transactions via electronic OTC Bulletin Board or privately-held OTC Markets Group.

Most of us must have heard about the term “penny stocks”, often referred to as highly speculative investments.

In recent years, with more startups and small businesses flooding the market, penny stocks have been gaining lot of attention. It should be noted like other publicly traded stocks, a penny stock gets listed on an exchange through an initial public offering (IPO).

According to the Financial Industry Regulatory Authority (FINRA) data, in Feb this year, there were 1.9 trillion transactions on OTC markets, an increase over 2,000% from the previous year. This can be attributed to the Covid-19 pandemic, making the stock market investment a favourite pastime among Americans. Now, whether the boom in penny stocks will last or not can be discovered only in the future; however, for those who are naïve to this term, let us first discuss the meaning of penny stocks. 

What are penny stocks?

Penny Stocks refer to the stocks or shares issued by a small-sized company trading at less than AU$5.00 per share. Usually, penny stocks are sold and purchased through over-the-counter transactions via electronic OTC Bulletin Board or privately-held OTC Markets Group. 

Typically, penny stocks are associated with small companies and are purchased and sold infrequently. This means that they have low liquidity and do not have ready buyers in the market. Since there is an absence of buyers for penny stocks, investors may sometimes face difficulties selling these stocks. Due to their lack of liquidity, penny stocks are mostly considered very risky. 

Related Article: Five ASX-listed penny stocks that made a splash this week

Why is there a need to regulate penny stocks trading?

Due to higher volatility, penny stocks involve both higher degree of risks as well as higher rewards. Penny stocks are best suited for those investors who have a greater tolerance for risk. Penny stocks are used by small businesses and startups to gain access to public money. Investors should be well-informed before making any investment in penny stocks. Penny stocks are subject to manipulation by stock promoters, and many times, investors fall prey to their tactics such as “pump and dump scheme” and make huge losses.

There have been several precedents when fake companies have duped investors by guaranteeing huge profits. The victims thus suffered massive losses.

Therefore, the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) have put in place specific regulations and compliances to protect investors who are trading in penny stocks.

What are the advantages and disadvantages of penny stocks?

  Advantages:

  • Inexpensive or low prices: Since the price of penny stocks is comparatively low, investors can own a diversified portfolio comprising penny stocks as well.
  • Yield can be high: Since penny stocks are highly volatile, they may give higher yields in a short fame of time. Thus, if the market conditions are favourable, penny stocks can be highly rewarding.

Disadvantages:

  • Involves higher risk: Penny stocks investment involves risk than other listed companies or exchange-traded funds (ETFs), as a small percentage change leads to a huge change in process.
  • Almost negligible earnings: Investment in penny stocks barely pays any dividend.
  • Penny stocks investment is subjected to Fraud risks.
  • Higher probability of bankruptcy: It is believed that the companies issuing these shares have unstable operations, creating chances of going bankrupt more easily.

Related Article: Look at these five attractive global penny stocks

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