What is a Penny stock? Is it worth investing in Penny stocks?

What is a Penny stock? Is it worth investing in Penny stocks?

It may be pertinent to first define what a stock is, and then a penny stock.

A stock is a unit used in measuring the stake or ownership of a publicly quoted company. In other words, a stock is a measure of the vested interest that an investor has in the ownership of a publicly quoted company.

When a company is quoted publicly, it simply means that the shares of this company listed on a financial exchange so that the shares can be bought or sold by the trading public. An exchange is a venue or marketplace where buyers and sellers of an asset or a stock can come together to do business i.e. transact. Since a portion of a publicly quoted company is owned as shares by members of the public, you can decide to buy or sell stocks by dealing with another person or entity who holds the shares of the company of interest.

Now there are a special category of stocks known as penny stocks. These are stocks which are priced at below $5, and which are traded on exchanges known as the Over-the-Counter (OTC) exchanges. Companies whose stocks are classified as penny stocks are generally not heavily capitalized, “blue-chip” companies.

Penny stocks are also known in professional circles as small cap stocks. Sometimes, the terminology is also used to describe stocks whose prices are less than one cent; these are the nano stocks or microcap stocks. Generally speaking, the market capitalization of penny stocks is less than 500 million dollars.

Penny stocks are typically listed in the Over-the-Counter exchanges or the Pink Sheets, and also on regular exchanges. This is also considered a secondary market and traders are free to buy and sell penny stocks on platforms that are connected to the OTC exchange.

Why Do Prices of Penny Stocks Have Huge Swings?

Penny stocks tend to have larger swings in price that conventional stocks or blue-chip stocks. This is because the circulating supply of stocks is typically smaller than for blue-chip stocks. Penny stocks are shares of companies with smaller market capitalization. This means that the number of shares outstanding for trading are also smaller. When there is a smaller circulating supply and a large demand, the price swings will be larger.

This is why huge companies like Tesla may only have 10% move on a very volatile trading day, but a penny stock could have moves of 100%, 200%, etc in a single trading session.

However, what gives penny stocks the large swings and potential of making huge profits is also the albatross of this category of stocks. Sometimes, it is possible for a trade to hit a profit target and not get triggered because of the relatively illiquid nature of these stocks. There is also the risk that prices could plunge heavily and rendered the penny stock almost worthless.

What Penny Stocks Should You Be Trading?

Not all penny stocks are listed in the OTC exchanges. Yes, it is true that majority of them are traded over the counter, but some are listed on the regular exchanges. The beauty of the exchange-listed penny stocks is that some of the pitfalls of the OTC-listed stocks are avoided. Some of these pitfalls include the illiquidity that sometimes bedevils the OTC-listed stocks. Furthermore, an exchange-listed penny stock is more regulated and the chances of being sold a worthless pump-and-dump scheme are virtually eliminated. Furthermore, exchange-listed penny stocks are required by the conditions set out for listing, to provide public information about their activities and their financials. That way, you get to know that the company that offers a penny stock for trading is actually in business and engaged in economic activity.

Some Facts About Penny Stocks

  1. Penny stocks can be traded in two directions: long (buy) and short (sell).
  2. Penny stocks can be traded on leverage (especially high on stock CFDs).
  3. Most traders who trade penny stocks, do so on an intraday basis.

Penny Stock Trading Basics

Penny stocks are also subject to forces of demand and supply, and also to sentiment. Indeed, many authorities on stocks believe that sentiment plays a bigger role in trading decisions that technical or fundamental analysis. However, it needs to be said that the fundamentals of a penny stock have a role to play in its sentiment, and this also influences the demand and supply of a stock. The demand and supply of a penny stock is dictated by the following factors.

Penny Stock Fundamentals

The prices of penny stocks are sensitive to market news. The market news determines the intrinsic value of a stock, and are also known as the fundamentals. Market fundamentals could be a function of intrinsic events, in which news from within the company may affect the prices. We also have extrinsic factors, in which news from outside can influence the price of a penny stock.

A) The Earnings Reports

The earnings report is one of the major movers of price of penny stocks. The most important data to penny stocks traders in an earnings reports is the profit/loss made for the quarter or the year, and the revenue. Also important is whether the numbers are an improvement over the previous quarter/financial year, or whether the performance has dipped. The key performance metric is the earnings/loss per share, which is the net income of the penny stock company divided by the number of outstanding shares.

A penny stock trader who uses the earnings report to trade would be looking out to see if the actual number is higher or lower than the consensus number. Usually, economists provide a consensus guidance on what they think the earnings will be. The trader’s job is to check to see by how much the actual number deviates from the consensus number, and if the actual was higher or lower than the consensus. The next thing is to check to see if there is improvement or retrogression from a previous quarter or year, or from a similar period in the last year. Good EPS numbers create a positive sentiment, which leads to increased demand for a penny stock, causing a rise in price. Bad EPS numbers, poor performance from one quarter to another, of from the same period in the previous year, produce a negative sentiment, leading to a drop in demand and fall in price.

B) Internal News

Internal news also affect the prices of penny stocks. For instance, a change in top management, death of a top member of the board, change in ownership via merger and acquisition, are all triggers of penny stock prices.

C) New Product Announcement

Announcement of new products with heavy commercial value (such as launch of a vaccine) are positive triggers for a penny stock. A negative product announcement (such as product recall, setback in clinical trials, etc) are bad for penny stock prices.

Price Quotation System

As with all assets traded in the financial markets, prices of penny stocks rely on a two-quote system in which there is a bid price (on the left) and an ask price (on the right). The difference is known as the spread.

Penny Stock Position Sizing

The unit of measurement of the size of a stock trade is usually in units, but many brokers have devised a system to match unit sizes to lot sizes. When you go on a broker’s platform, try to find out how many units of a stock are equivalent to 1 Standard Lot trade size. This will help you determine how to structure your position sizes to match the acceptable risk levels for your account capital. You will also have to find out the minimum trade size allowable by your broker for trading penny stocks.

Is It Worth Investing in Penny Stocks?

The reason why people get interested in trading penny stocks is because they have potentials of giving very high returns, despite their relative illiquidity and greater risk profile. There are loads of examples of stocks that started off as penny stocks and are now heavy duty blue-chip stocks. Amazon traded at $2 per share during its IPO in 1997. In July 2020, it was worth more than $3,300 per share. Apple once traded under $1 per share. Turtle Beach Corporation went from $2 to $30 in 2018. Monster Beverage Corporation went from 6 cents a share in the early 2000s to more than $70 per share nearly two decades later.

There are also stocks that have hit multiple returns in a matter of weeks, months and even days. In contrast, it is harder for a blue-chip stock to achieve a 10-fold rate of return in such a time frame. That is why people will continue to flock to penny stocks, even when it is obvious that there are many of these stocks that will eventually become worthless.

It is imperative for investors to do proper research before trading penny stocks, as they are known for their high volatility and quick response to market news. You must also be wary of pump-and-dump schemes. These schemes are situations where unscrupulous people float false positive news about a stock and hype it to create demand, thus driving the price higher, only for the promoters to sell and cause prices to crash while cashing out. Remember Leonardo DiCaprio’s character in a scene on the Wolf of Wall Street, hyping a dead-beat penny stock? You need to watch out for people like these.

That said, trading penny stocks can be very rewarding if you do it properly by going for those listed on exchanges, doing proper analysis and following the market news. You should also know how to trade them. Proper entries, management and exits using proper position sizes are a large part of the equation. You should also consider the brokers that we have here, offering penny stocks for trade.

Show Results