You don’t have to search too hard to find some pretty amazing success stories where a penny stock has soared in value and earned some canny investors a decent profit, but on the flip side, there are also plenty of examples to be found where the cash has been wiped out when the stock flopped, or even worse, didn’t exist in the first place.
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, but before you decide to buy a stock in the first place, it is definitely worth taking a look at the various pros and cons in order to hopefully make a more informed decision.
Understanding penny stocks
It is well worth reiterating exactly what penny stocks are, so that you completely understand exactly what type of investment you are putting your cash into.
Any equity that is trading below $5 a share is considered to be a penny stock. These shares are issued by the company and trade through the over-the-counter bulletin board or Pink Sheet electronic quotation systems, rather than through the mainstream indexes, simply because they are considered too small to meet the listing requirements of the NASDAQ or NYSE exchanges.
It is highly relevant to remind yourself of these circumstances, because when you are trading penny stocks, you are not operating within an environment that is as highly regulated as the mainstream indexes and you can experience issues with liquidity and volatility as a result.
Big price swings
You definitely need to be prepared for the volatility, as penny stocks are traded in small volumes compared to the main indexes and through a much smaller group of investors.
This can create the perfect storm where price swings can remind you of a rollercoaster ride, with prices rising and falling in big increments, in a very short space of time.
It is fair to say that if you are a cautious investor and have a what could be classed as a low risk tolerance, trading penny stocks is probably not going to be for you. In general terms, it tends to work out with a fair number of penny stocks, that you might get a small window of opportunity to to take a decent profit when riding the price wave, miss that boat, and you could soon be staring at a loss compared, as it can all happen that quickly.
If you like the buy-and-hold approach favored by the likes of Warren Buffett, penny stocks are not going to be your thing, but if you are prepared for a mix of winning and losing investments, then there are potential profits to be made.
Always be wary of fraud
The minimal level of regulation in comparison to mainstream markets, thin trading volumes and a lack of detailed company information for investors to digest, are all perfect scenarios for fraudsters to try and make a killing.
Sadly, penny stock frauds can and do happen. This is because they are easier for fraudsters to manipulate the stock price for their own gain, which they can do in several ways.
A scammer might decide to trade a certain penny stock amongst a group of like-minded fraudsters with a view of artificially inflating the price, before unloading the stock to an unsuspecting investor, commonly known as a pump and dump
Another scam is when fraudsters talk up the potential of a penny stock and promote it as an opportunity not to be missed. If they manage to fuel an unjustified rise in the stock price, they can then take advantage of this scenario by selling for a profit, before the realization sets in.
Do the fundamentals
Penny stocks trade in what could sometimes be justifiably called shark-infested waters, but that is not to say that there are not some genuine opportunities to take advantage of.
Finding the right penny stock and avoiding the scams is not so difficult if you are diligent and do the fundamentals before parting with your cash. This means taking the time to scrutinize the company’s available financial records and sourcing information about the business from trusted and reliable sources.
It should be remembered that almost every large company started out life as a fledgling stock and probably spend some time trading as a micro-cap company
This means that some of tomorrow’s future stars are potentially lurking amongst the penny stocks. Do your research and when you find a company that ticks all of the right boxes, alongside some useful clues, such as key people inside the business buying stock options, then there is a chance that you may have found a penny stock that could earn you a profit.
Dominic Banks is a self-taught stock trader who is sharing his knowledge online through his informative and useful articles.