The stocks which trade at a very low price and have a very small market capitalisation, are said to be penny stocks. Generally they trade below $5 and have a market capitalisation of less than $300 million. They are associated with small and sometimes infant companies. Since, it is not easy to buy or sell them; therefore they have a low trade frequency. Due to this, they suffer from liquidity crunch and so are avoided by the traders, but good penny stocks are on radar of value investors. As the movement in penny stocks is highly unpredictable, therefore a great variation in bid-ask ratio is observed. These kinds of stocks can be very easily pumped and dumped due to their very small market capitalisation.
As penny stocks belongs to small companies, and small companies have a large potential of growth. Therefore they also offer a large growth potential to their investors. Also, as they are of very small size, therefore in a market correction they bleed badly. Just like a paper flying during a storm. But, this goes in both the direction, i.e. during bull run and bear fall, consequently adding greater risk to them.
WHY ARE PENNY STOCKS RISKY?
Every investor says penny stocks have high risk associated with them. So, let’s find out, why?
- LACK OF INFORMATION AVAILABLE:
As penny stocks belong to companies which are very small. Therefore they are unknown to many, as a result very low amount of initial investments are made. And as it is important for a stock to undergo good consolidation, to show a decent up move. Therefore lack of buying makes movement tougher. Also, for making an investment decision it is very important to be well informed. But in cases regarding these stocks, not much information is available. Thus reaching to a proper conclusion becomes even more difficult.
- LACK OF LIQUIDITY:
It is a known fact about penny stocks. Low liquidity makes the stocks more manipulative. As some traders can exercise pump and dump. Large amounts of stocks are bought in a very small span of time. Once the price gets pumped up, owing to this hype many are attracted towards the stock and they buy it. And then it is dumped.
- CHANCE OF FRAUD:
The above kind of activities has become frequent in cases of penny stocks, and due to this fraud many investors lose their money.
- LACK OF FAVOURABLE HISTORY:
Penny stocks belong to companies which are either new or on the verge of bankruptcy. In both these cases a good history is not present. It is a general tendency of investors to predict future on the basis of past. And absence of a good past discourages them to forecast the future potential.
PROS OF INVESTING IN PENNY STOCKS:
- Has a feature of fast linked with it.
- They offer a good business idea at a very low price.
- Every blue chip company was once a small company. So, even if you are able to identify one good penny stock and hold it, you will definitely make good money.
CONS OF INVESTING IN PENNY STOCKS:
- They lack liquidity.
- Very high risk associated with them.
- High probability of fraud.
- Inexperienced management.
WHEN DOES A PENNY STOCK, CEASES TO BE A PENNY STOCK:
All the current blue chip companies have had a very small beginning. They all have been a penny stock during their infant stage, but they no more are a penny stock. So, let’s discuss about the positive changes responsible for this transformation:
The movement of a stock is replica of its company’s performance. When a company performs well the stock moves positively and when the company suffers in delivering good results the stock also descends. As a result of this the stock price increases and so does the market capitalisation. When the market capitalisation of a stock crosses $300 million mark it becomes a micro cap stock. So, the most important point for a stock to be out from the list of penny stocks, is to grow into a large company. When the market capitalisation of the stock will increase, it will climb up in the list.
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