Can penny stocks help you create long-term wealth?

Summary

  • Penny stocks are gaining popularity due to less obstacles in market entry and potential to turn very small amounts of money into huge gains.
  • Though penny stocks are mostly traded through OTC transactions, some penny stocks are also traded on major exchanges.
  • Limited liquidity is the primary reason for the low price of penny stocks, which in turn widens the bid.

The stocks of small companies, which are generally traded for less than $5 are known as penny stocks, as defined by the US Securities and Exchange commission (SEC). They are also known as stocks under $5, microcaps, and small caps. Penny stock are mostly traded through over-the-counter (OTC) transactions. OTC transactions are carried out with the support of OTC bulletin (OTCBB) boards or OTC market groups that are owned privately. These kinds of transactions have no trading floor like big exchanges, and the quotations are all carried out via electronic means. The operations and functioning of the electronic trading service, OTC bulletin board, is regulated by the Financial Industry Regulatory Authority, which ensures that all the companies trading in penny stocks are maintaining up-to-date financial statements and meeting the minimum standards. The penny stocks carrying much greater risks are the ones that are listed on publications like the Pink Sheets. These stocks do not have much regulatory requirements, and therefore, give less insights to the investors for making sound trading decisions.

Though penny stocks are mostly traded through OTC transactions, some penny stocks are also traded on major exchanges, like NASDAQ (National Association of Securities Dealers Automated Quotations) and NYSE (New York Stock Exchange). Like these large exchanges, OTC market is also supported by the online brokers, even though it doesn’t factor into the trade. The penny stocks that are listed on big stock exchanges boost the confidence of investors as these exchanges have certain minimum requirements, like minimum market capitalisation and annual listing fees, which reduce the volatility associated with these stocks. If in case the stock falls below the threshold limit of price per share or market capitalisation to meet the minimum requirements, the stock can be de-listed from the exchange, and it may be shifted to the OTC market. In such cases, the stocks will still be owned by the investors, but their value will relatively fall after the company is de-listed.

Can penny stocks help in wealth creation?

The answer is YES! But it is important to understand the differences between trading regular stocks and trading penny stocks. Penny stocks are gaining popularity due to less obstacles in market entry and potential to turn very small amounts of money into huge gains. A notable thing to keep in mind is that stocks listed on the traditional stock exchanges must not be considered as penny stocks, no matter how low their price falls.

There are basically four tiers of penny stocks: Tier 1 penny stocks are listed on large exchanges like NYSE and NASDAQ, which are considered better than the OTC penny stocks as the scope of manipulation is less due to the requirement of providing financial information to the exchange. The tier 1 penny stocks are generally priced less than $5, but may even be above it, while the Tier 2 penny stocks fall in a price range of 1-99 cents. The Tier 3 penny stocks, or the sub penny stocks, cannot be listed on large exchanges, as their stock price is a penny per share, or even less. The Tier 4 penny stocks, or triple zero stocks, fall in a price range of 0.0001 and 0.0009 cents per share, and the investors who buy these stocks first get the maximum benefits, making these stocks associated with the ‘hot penny stock’ alerts.

How to invest

To invest in penny stocks, an account must be opened with a broker, after filtering out the brokerage firms that do trade in them, such as Fidelity, Firstrade, and Zacks Trade etc. The fees charged by the broker per trade should be considered as it impacts the overall gains from trade if they charge a high commission. Penny stocks are cheap because the company issuing them may be new or has lost value due to regulatory challenges or poor business performance. But still investing in penny stocks could prove out to be a good decision due to many reasons. Because of being priced so low, penny stocks have the potential of doubling, tripling, or even quadrupling the returns on investment, that too at a rapid speed. The main incentive of investing in penny stocks is that it can help you get rich quickly, as compared to the long-term commitments in the traditional stock markets. But these high returns may come with an even higher risk, and therefore, investments should be made in the penny stocks only as much as you can afford to take risk and lose at the stock exchange.

There is a range of investment risks associated with penny stocks. Limited liquidity is the primary reason for the low price of penny stocks, which in turn widens the bid/ask spread. The investors have very limited information to form their decisions in case of OTC penny stocks, and they also face the risks of fraudulent trading activities due to limited overnight and regulations. There is a greater potential of bad news in case of penny stocks, because of few sellers owning many shares, creating high volatility with very less time to react. Investing in penny stocks means investing in small companies that may be distressed or may be on the verge of solvency, and these companies may go out of business anytime, with no scope left for you to recover your investment. In some cases, the promoters may set traps with fraudulent deals and pump-and-dump schemes, and the investor must be cautious to not fall for them.

To steer clear of such risks, the investor must have a mindset of considering penny stocks as speculations, and not investments. Listed stocks should be given higher preference in comparison to OTC stocks, and even these should not constitute more than 10% of your total investment portfolio, as these are not stable investments, like mainstream shares and bonds.

Diversification of the penny stock investments is important, as pay offs are possible only in a small proportion of investments. While investing, the core value of the company with its growth prospects should also be evaluated, and investments should be made in companies that offer potentially promising returns. Traders can use stock screeners to find the potentially lucrative penny stocks with specific parameters, such as news break, floatation of shares, and trading volume. Investment-worthy penny stocks can also be found through fundamental analysis which uses the available company information like revenue and debt, as well as technical analysis which uses patterns like price dips and share consolidation, and financial ratios of companies like leverage ratio and performance ratio.

Penny stocks can prove to be a game changer if they turn out to be profitable, but it is also important to understand the probability of losing your money. Therefore, invest only as much as you can afford to lose. Paper trading of penny stocks is a good way to start and learn about how to make profits in this market, without investing and losing real money.

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