- Penny stocks are the common stocks that are traded below £1 and have a market cap of less than £100 million in the UK.
- Penny stock trading-indicators, like RSI and others, help in determining for how long penny stocks should be held.
Buying or selling penny stocks is extremely risky due to their exposure to high volatility, low liquidity, manipulative nature, lower regulations, and their lack of consistency in performance. Thus, it is wiser for investors to avoid penny stocks for a long-term profitable investment. However, you can invest in them for a short period of time.
What are penny stocks?
As per the US Securities and Exchange Commission’s definition, the stocks of small companies, which are generally traded for less than US $5 are known as penny stocks. They are also known as stocks under US $5, microcaps, and small caps. They can be classified as the stocks or shares which trade below £1 in the United Kingdom. Penny stock companies have a market cap below £100 million in the UK, and below US $300 million in the US. They are mostly traded through over-the-counter (OTC) deals. These are carried out with the support of OTC bulletin boards or market groups, which are mostly privately owned. Such transactions have no trading floor like stock exchanges.
The 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.
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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 New York Stock Exchange, and these penny stocks boost the confidence of investors as the big exchanges have certain minimum requirements, like minimum market capitalisation and annual listing fees, which reduce the volatility associated with these stocks.
Also read: 5 penny stocks with high growth potential
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. It is important to maintain the distinction between traditional stocks and penny stocks by keeping in mind that no matter how much the price of the traditional stocks fall, they must not be considered as penny stocks.
Why invest in penny stocks
Although penny stocks are cheap because the company issuing them may be new or has lost value due to regulatory challenges or poor business performance, still it may prove out to be a profitable decision to invest in them due to high potential of growth in value at a rapid speed, unlike long-term commitments in traditional stock markets. But as higher returns may come with even higher risks, investments should be made considering how much you can afford to lose at the stock exchange.
What are the risks?
The basic reason why penny stocks are low priced is its limited liquidity. Also, due to limited oversight and regulations of OTC penny stocks, the investors have very limited information to form their decisions. A bad annual report or even one small bad news can create huge volatility in case of penny stocks!
Therefore, 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 volatile in nature, much more than mainstream shares and bonds.
How Long Should You Hold Penny Stocks
Unlike the movements of traditional stocks, penny stocks don’t generally track the cyclical trends in the market. Instead, they follow the general market trends in their respective sectors, and very minimum fluctuations in the prices can lead to greater gains and loss in percentages due to their high volatility. Just as a rising tide can lift all ships, a sector-wide positive or negative event affect, in general, all penny stocks belonging to it. Thus, it is very difficult to assess the time frame to hold penny stocks.
All the companies hit their peak at some point, but the important point is to understand what comes after hitting the peak. The stocks may collapse, or consolidate, depending on a lot of factors. After the stocks pull back to a level lower than the peak, the new level is always generally higher than the previous highs. Thus, the solution is to pay attention to certain indicators, and track if the stocks are overbought or oversold. Usually, the overbought shares witness a fall in price, while the oversold shares show a potential of rising prices in the upcoming months or weeks.
The Relative Strength Index (RSI) indicator is an easy tool to assess if a penny stock is overbought or oversold. It has a range of 0-100, where the oversold level is represented by 0-30, while overbought is represented by 70-100. As the RSI value keeps oscillating daily, it is not the sole indicator to depend on, but it is quite useful in monitoring the demand for penny stocks. For example, if you buy a penny stock with RSI value 50, and then its value increases to 80, then it doesn’t mean that you have to outrightly start selling. This just alerts you to pay attention and assess for how long you are going to hold these stocks.
Stochastics, which is an indicator like RSI, also shows if the penny stocks are overbought or oversold. But in a sideways market where the trend isn’t clear, Stochastics can prove out to be a better indicator than RSI.
Another indicator Moving Average Convergence/Divergence (MACD) keeps a track of the changes in trends of penny stocks with respect to strength, direction, momentum, and duration. This helps in understanding if the trend is bullish or bearish.
Bollinger Bands is another indicator that provides the investors with the upper and lower limits of penny stocks, and helps in plotting these limits during particular trends, as they widen and narrow down continuously. Wider bands represent higher market volatility, and this can help in deciding whether to hold the stocks or sell them.
How to proceed
Penny stock trading indicators may be used in combination to determine when to buy penny stocks, and for how long to hold them. But these indicators are also not fully accurate, as one little shock can significantly influence the penny stocks, making all indicators useless. Thus, holding penny stocks for too long is a very risky deal, and they can be held for 5 minutes or even 5 months, depending on the risk-aversion of the investor. But penny stocks shouldn’t be considered as long-term investments and shouldn’t be held for over six months in general.