If you have a high risk appetite, penny stocks could be a good investment. These low-priced stocks are usually owned by lesser-known companies and can turn out to be multi-baggers. However, although investing in penny stocks can yield high returns, it is essential to be aware of the potential risks. Only a few select penny stocks turn out to be winners, but most of them are questionable investments. We explore why they are so risky, how best to invest in penny stocks, and whether there are alternatives to investing in penny stocks.
What are Penny Stocks?
Penny stocks typically trade at price values below $5. These stocks belong to small companies that usually have very little information available in the public domain. Most of these stocks are traded on over-the-counter (OTC) markets. Only a handful of publicly traded stock companies are listed on the New York Stock Exchange (NYSE) or Nasdaq (NDX). Penny stocks are also known as micro-cap stocks, owned by companies with a market capitalization of $300 million or less.
Is it profitable to buy Penny Stocks?
Although penny stocks can be profitable, they can also lead to significant losses. Penny stocks are highly volatile, with wild price swings. Since they have very low prices, a small price adjustment can lead to large changes in the holding value.
For example, imagine that you own 100 shares of a $1 stock of company A. If the stock price rises to $1.5, it will cause the price to rise 50%. Your initial investment of $100 will grow to $150. Similarly, a drop in the stock price to $0.60 will represent a 40% loss on the stock.
Also, since penny stocks are mostly traded in over-the-counter markets, there is not a lot of trading volume in these stocks. This means that you may not find a buyer or seller for these stocks when you want to trade.
What is the downside of Penny Stocks?
There are a few challenges to investing in penny stocks. As with any investment, it is very important to undertake thorough research. Unfortunately, information on most corporations is not available in the public domain. This makes it easier for large investors to get rid of stocks as well as possible fraudulent schemes.
To protect your investment, it may be wise to invest in penny stocks that are traded on an exchange. These major exchanges require certain disclosures and accounting standards to be followed. This makes listed companies liable to some degree, although fraud can also occur in large, well-capitalized companies.
What are Pumping and dumping diagrams?
If you invest in penny stocks, beware of “pump and dump programs”! These schemes involve fraudsters driving up stock prices by spreading misinformation about companies. They promote the company on social media platforms, attracting naïve investors to buy the stock.
Once the demand-triggered price of these stocks rises, fraudsters dump their holdings in the market. This results in a period of falling stock prices. The losers are often small investors making huge losses, with no buyers on the other side.
How Fraudsters Use Social media in pumping stocks
Fraudsters often rely on social media platforms like Twitter (TWTR), Facebook (META), and Reddit to manipulate investors into investing in penny stocks, for their own profit. They use these social media sites to create a buzz around a penny stock. This buzz attracts attention and people start investing, driving up the price of a stock.
The recent frenzy of meme stocks is a result of the free availability of information on social media platforms. Companies like Bed Bath & Beyond (BBBY), AMC Entertainment (CMA), and GameStop (EMG) saw their shares plunge to their lowest levels and soar in a single day.
Memesters are improperly taking advantage of social media platforms to make huge bets on these stocks and earn massive profits. Meanwhile, less experienced investors suffer huge losses.
How to Invest in Penny Stocks
If despite the danger, you want to invest in penny stocks, there are steps you can take to mitigate the risk.
1. Invest according to your risk appetite – in other words, don’t invest more than you can afford to lose.
2. Don’t invest for the long term – unlike other stock market opportunities, penny stocks are rarely “buy and hold” investments. Keep an eye on penny stock investments so you can take advantage of short-term price fluctuations. A penny stock does not necessarily follow the long-term uptrend.
3. Don’t diversify – this may seem the opposite of what you learned about investing, but it doesn’t apply to the penny stock market. When it comes to penny stocks, don’t bet your money on multiple horses.
Imagine you invested $1,000 in five stock companies and allocated 20% to each. If two out of five stocks generate positive returns, you could end up losing all your capital.
4. Book your losses – don’t try to average purchases while investing in penny stocks. If a penny stock drops significantly in percentage terms, it’s usually better to take a loss and get out. A downtrend can often mean that something is fundamentally wrong and prices may not go up.
5. Only buy liquid stocks – this will ensure that you always have a buyer when you want to get out of the stock. For example, if the average daily volume for a stock is 100 shares over the last month and you own 500 shares, you may find it difficult to unload when you want to sell.
6. Brokerage Commissions – try investing in penny stocks through brokerages that do not charge commissions. The low earnings on these investments may not justify the huge commissions paid to brokers.
7. Do your own research – don’t believe hearsay or follow stock market frenzies, as this can put your money at risk.
How to Research Penny Stocks
There are stock research tools to research penny stocks. TipRanks Penny Stock Screener tool is one of the best. It presents a list of the best penny stocks to watch. You can filter this list by different data, such as how Wall Street analysts value stocks, as well as their average price targets. This can help you choose attractive penny stocks.
Penny stocks often belong to the healthcare sector, as upcoming pharmaceutical and biotech companies may have a small market capitalization. They are mostly in the clinical stage of drug development. These companies become hot stocks overnight if one of their drugs gets the green light from the US Food and Drug Administration (FDA). Likewise, the market is flooded with small fintech companies and banks that are likely to be taken over. Look for these potential long-term winners in TipRanks’ Penny Stock Screener list to make informed investments.
Here is a screenshot of some of the top penny stocks, with the biggest rise, using the Penny Stock Screener:
Additionally, the filter presents data, such as insider trading, hedge fund activity, retail investor sentiment. This unique data can help you make informed investment decisions.
Alternatives to Penny Stocks
If you have a small amount to invest in the stock market and prefer low-risk investments, fractional shares may be best for you. Fractional shares allowed investors to invest in well-capitalized companies, typically the largest in their respective industries. Fractional stock investing is available for US stocks and exchange-traded funds (ETFs).
Imagine you want to buy shares of tech giant Alphabet Inc. (GOOGL) but only have $1,000 to invest. Fractional stock trading allows you to own a fraction of the shares of expensive companies.
Brokerages like Charles Schwab (SCHW) and trading platforms such as Robinhood (HOOD) made this possible. The TipRanks smart wallet also supports fractional shares, to give you better insights.
Additionally, several large companies have conducted stock splits to make their shares more affordable, thereby attracting a larger investor base. Overall, stock splits increase liquidity and make the stock affordable for small individual investors.
Final Thoughts on Penny Stock Investing
Investing in penny stocks is risky. However, if this is a risk you want to take, given the potential for outsized returns, be sure to follow the basic guidelines. Conduct your own research and only invest in high volume stocks to protect your investments. Use a penny stock analyzer that lets you tell analyst ratings and price targets to have the best chance of finding safer investments.