What Are Penny Stocks? How Do They Work?
This article will, hopefully, help investors gain a better understanding of penny stocks. If you’ve ever wondered how do penny stocks work, you may have been looking for a way to expand your investment strategy. Thus, the article will discuss the ways to trade penny stocks. It will also illustrate what their main advantages and disadvantages are.
Of course, any discussion of how a portfolio of penny stocks works must consider the risks. When investors trade in penny stocks, they incur a different set of risks from regular stocks. Thus, they require a different approach or strategy for trading. Nevertheless, in explaining how to invest in a penny stock, the article will highlight some of the risks involved.
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An easy penny stock definition might be the following. A penny stock might refer to any equity valued at between $1.00 and $5.00. Often, penny stocks trade for much less. Trading penny stocks involves considering, typically, shares of small companies whose main characteristics are the following.
- They are illiquid; that is, they need cash and they cannot be sold easily.
- They are highly speculative.
The third aspect to note about how penny stocks work is that their engine is speculation and their fuel is called “the press release.” Mining companies, for example, might issue a press release about a discovery. Gold companies and others tend to emphasize the ease of extraction and the potential grades for instance.
To highlight the value of their find/product/service, a penny stock company typically relies on an investor relations or public relations firm to manage and write “releases” that are sexy. The right combination of amazing results/potential and mesmerizing writing are the very elements that can drive a penny stock to make huge gains. But it’s often just the proverbial hot air.
Many penny stocks are traded on Over-The-Counter (OTC) markets. The fact that these are small and, shall we say, “less regulated” than the bigger and more established markets such as the NYSE, maximizes the rewards…and the losses.
Overall, the picture looks rather risky. And, there’s no doubt that it can be. But, if you learn more about these fascinating and easy ways to get into the stock market, or to diversify your portfolio, you can develop strategies to manage the risk.
Trading penny stocks first of all requires that investors learn about their main trading features. Penny stocks differ from other stocks for a number of reasons. The first distinguishing feature is that they are less bound by regulations. Still, there’s no reason why penny stocks, despite their speculative character, cannot be traded on major exchanges.
To manage that risk, first time, or exploratory, penny stock traders should limit themselves to penny stocks listed on the NASDAQ rather than an OTC scenario. Simply put, investors will be better protected this way. Penny stocks have small market caps and trading volumes, but when they break out, they can produce exponential gains.
Thus, avoid penny stocks traded OTC and small markets until you have tasted the risks and opportunities they offer in the more established exchanges. The advantage of a main exchange as opposed to an OTC is the following.
Trading that occurs in small (OTC) markets may lack the regulations that protect their investment. This keeps unsuspecting investors of the economic situation of the companies. That’s why penny stocks have earned a bad reputation as portrayed in Hollywood movies like The Wolf of Wall Street and Boiler Room.
Yet, the bad reputation also hurts legitimate companies with a legitimate shot at graduating to the senior exchanges. So much for the regulatory risks. Now, the other risks have a more personal nature. Those considering penny stocks better have a strong stomach and even stronger patience.
Penny Stocks Trading
Indeed, trading penny stocks means being able to endure long periods of inaction. That’s because penny stocks often experience large price fluctuations, concentrated in very short periods. These fluctuations can catch most investors off guard. Because most of the time, they occur in spurts. You see, penny stocks tend to trade in long periods of low prices, producing slightly wavy curves.
This characteristic—the long periods of inaction—is one of the reasons they can be so convenient to trade. Penny stocks are more accessible to ordinary traders. Still, because of the risks, they might best be left to the experienced trader. Thus, penny stocks involve high speculation, little information, low liquidity, and wide bid-ask margins.
Thus, trading penny stocks, often means being subjected to patterns that end up being controlled by a handful of market-makers. The most negative aspect of this kind of trading is that it lends itself to a high degree of market manipulation. Shareholders and on the part of participants and promoters, which leads to a high possibility of fraud.
Add to that the typical nature of penny stocks offering little information to investors and you can see that the odds are almost casino like. Indeed, that could be part of the appeal. Investors, especially inexperienced ones, can easily get caught up by the promise of returns that are often too good to be true.
Even for those who have traded before, the expectations attached to penny stocks are so unrealistic Penny stocks attract investors in the same way that slot machines attract gamblers in Las Vegas. The odds are higher for the penny stocks. But, there are enough examples of penny stocks that have hit the big time to suggest that there are real winners in the speculative mist.
Many investors do, in fact, allow themselves to be beguiled by often unreal expectation of high returns that might not occur even after a long period. Some recent examples of success, that is penny stocks that ended up making it to the big time, include Monster Drink Beverage (NASDAQ:MNST). That company went from $0.70 to over $40.00! Then there’s GGP Inc (NYSE:GGP). It went from almost sure death at $0.33 per share in 2001 to trade now at about $23.00. Such penny stocks are not black swans. But, they are rare.
Here are some recent penny stocks worth considering:
Penny Stocks for 2017
| Company | Stock Price | Market Cap |
| DroneShield Ltd (ASX:DRO) | AU$0.35 | AU$13.42M |
| Houston Wire & Cable Company (NASDAQ:HWCC) | $6.35 | $102.40M |
| Nobilis Health Corp (NYSEMKT:HLTH) | $1.50 | $116.74M |
| Spectra7 Microsystems Inc (CVE:SEV) | C$0.46 | C$69.99M |
| Kraken Sonar Inc (CVE:PNG) | C$0.21 | C$17.76M |
| Memex Inc (CVE:OEE) | C$0.22 | C$26.16M |
| Department 13 International Ltd (ASX:D13) | AU$0.14 | AU$27.76M |
(Source: “Google Finance,” last accessed April 10, 2017.)
Penny Stocks’ Biggest Achilles’ Heel: Volatility
Still, there are more advantages to trading penny stocks. The main advantage about trading in penny stocks is the very thing that makes them risky: their high volatility. As any typical stock chart suggests, volatility in the stock market offers the best chance of finding gain. High volatility does leave most investors exposed excessive risk, leading to significant losses.
But, volatility is also the characteristic about stock markets that allows for profits. Thus, volatility, in the context of penny stocks, can be described as that double-edged sword that makes them attractive. Still, not all attractive things from afar maintain their luster up close.
Volatility is best left to those who have already loved and lost in the stock markets. It’s like playing poker; it benefits the experienced player but can penalize the beginner to a fault. Now, that’s just about it where the advantages of penny stock trading are concerned.
Some may be attracted by the “penny” aspect. The stocks look cheap. But, they’re not really cheap in the sense that stocks are priced. A cheap stock is one that offers a good return on investment, based on its price to earnings P/E ratio. The S&P 500—not penny stocks—has a P/E of about 26 times. That’s rather huge.
But its suggests that stocks trading at P/E’s of six, seven or even eight times offer good value. What stocks offer that? General Motors Company (NYSE:GM) has a P/E of about six. Penny stocks don’t have earnings. Typically, they lose money, thus their P/E ratio is mathematically undefined. Penny stocks represent companies that might never see a cent of earnings.
The penny stock investor should be experienced in the sense that he/she should know how to ask the right questions. It requires a lot of work to trade penny stocks successfully. The list of disadvantages of trading penny stocks might make you think twice about them.
The disadvantages of trading penny stocks all tend to increase the risk of a rather undesirable effect: the loss of money. Whatever your strategy in trading stocks, securing a gain is the only reason to be in the market. Thus, before anyone considers investing in penny stocks, the one overarching rule is to be adequately informed about the risks they are running.
As mentioned earlier, the main risk attached to penny stocks needs stressing. Penny stocks are almost always traded on non-regulated markets. Therefore, they are not subject to controls by vigilant authorities. This means that such stocks carry a disproportionate risk of ending up costing less than the paper on which they are printed.
Penny stock companies, because they operate outside the highly regulated exchanges, enjoy greater freedoms than the mainstream ones. That’s good for them, but bad for you, the average investor. The penny stock issuer does not have an authority to address. It is also not obliged to reveal their financials. As companies, in their operations, they can also take certain liberties.
For example, a mining company—which makes for a rather popular penny stock—might skip on governance and safety standards. The low liquidity, meanwhile, means that even when you’re ready to resell your penny stocks, there might be nobody out there willing to buy. You might be forced to wait until a buyer shows up or sell them at a lower price. Obviously both solutions, in light of the basic goal of investing (making a profit), are hardly ideal.
In sum, penny stocks offer few chances of finding the next Facebook Inc (NASDAQ:FB) or the next Apple Inc. (NASDAQ:AAPL). In 90% of cases, a penny stock investment will fizzle out. It’s a numbers game, but one best left to those willing to go beyond the numbers.
