By Arjun Chandrasekar.
Overview
Penny stocks are stocks that are valued at less than five dollars per share, hence the name penny, or small. Previously, penny stocks were only considered to be valued at under one dollar, but the Securities and Exchange Commission (SEC) decided to make it under five dollars. Penny stocks are generally traded for startups or very small companies, mainly because they have a small amount of money and investors. Because of this minimized liquidity, investors often can find it difficult to repeatedly buy and sell a penny stock; there is also a lack of buyers and sellers in the penny stock market. It’s much easier to trade stocks from a large corporation such as Facebook or Apple due to the sheer amount of investors buying and selling the stock.
Risk & Reward
Investing in penny stocks is high-risk, generally because the companies are startups with less funds and investors for support. But with risk comes reward. Since penny stocks sell at such low prices, investors gain the incentive to purchase large amounts of shares. For example, if an investor catches a new biotech startup selling for $0.50/share, and he has done his due diligence in analyzing the stock and seems to like it, it’s easy for him to purchase a lot of the stock.
Reasons for Failure
New to the market. Penny stocks, as mentioned before, are almost always companies that are new. This means that they have no track record or history that potential investors can analyze, which is harmful in many cases because investors generally look into companies with a successful record of growth or companies with high ROI. Also, startups are known to have a higher probability for legal issues such as fraud or corporate structure, which can immediately shut them down and put them into bankruptcy. This is never good for investors and an unreliable aspect of penny stocks. One example of penny stock fraud is called the “pump and dump” case. Pump and dump is the “illegal act of promoting stocks you own with false and misleading statements to sell when the stock price inflates.”(benzinga.com).
Reasons for Success
On the other hand, penny stocks can become very successful. Some penny stocks, right after their IPO, have shot up almost 75%. The upside to the low cost of penny stocks provides a significant motive for investors to buy shares. The average investor can buy even just 1 share without financial inflection. With a relatively small investment, penny stocks can promise big profits and a nice return straight to your wallet.
Conclusion
Overall, the allure of penny stocks is quite simple to understand. While they come cheap and promise big returns, you should always be weary of the downfalls. Because penny stocks are mostly new to the market, it’s hard for investors to want to buy in because of the lack of history or proven track record. Also, because of the low number of investors trading the stock, it can be hard at times to sell off your shares, causing even more loss. But for beginner investors, it’s great because of the low price and mostly low volatility. If you’re interested in testing the waters of investing in stocks, learning about penny stocks is a great idea.
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