Penny stocks have generated massive returns for equity investors, making them some of the most coveted investments among retail investors. However, the high risks associated with penny stocks, along with limited public knowledge about the issuing companies, generally hold back retail investors from betting on these multi-baggers.
The current bullish market trends, coupled with the hope of a market recovery as well as surging investor optimism and an increase in per capita consumer spending, should allow underlying start-ups or penny stock companies to expand their operations domestically and internationally.
With so much optimism, you may be wondering if you should start trading penny stocks. However, trading penny stocks is risky and it’s important to understand the pros and cons, as well as how to effectively trade penny stocks.
Read for a list of pros and cons of trading penny stocks, along with 4 strategies for effective trading.
Pros and Cons of Penny Stock Investing
Investing in penny stocks carries significant risks. However with high risks also come the opportunity to derive outsized gains and beat the broader markets. Here are some of the pros and cons of trading penny stocks.
The biggest benefit of investing in penny stocks is that they are relatively cheap.
Generally, a stock below the price of $5 can be considered a penny stock. A lower priced stock is attractive to traders or investors who have limited capital. So, if you have just $500 dollars to invest you can either buy 100 shares of a company with a stock price of $5 or buy two shares in a company with a stock price of $250.
Further, in case you have identified five penny stocks, you can allocate $100 in each of these companies and diversify your investment, which is an important step to mitigate some of the risks inherent in trading penny stocks.
Another thing investors should note is that almost every tech stock that is valued at a trillion dollars or more was a penny stock at some point in time.
Amazon stock was trading at $1.73 per share back in May 1997 and is now priced at $3,250. Similarly, back in July 1985, Apple stock was priced at $0.08 per share and is now trading at $127.84. Microsoft stock has risen from $0.10 in May 1986 to $250 in May 2021.
Thus, picking the right penny stocks can afford huge profits over the long term with very little upfront investment.
However, for every Amazon or Apple, you can also find hundreds of penny stocks that have crashed and burnt investor capital.
It is extremely difficult to pick a penny stock that can turn into a mega-cap stock over the course of two decades. The ideal penny stock should have a solid management team, a rapidly expanding addressable market, and improving profit margins.
Long-term penny stock investors should hope the company is well poised to beat consensus estimates quarter after quarter which will help it to beat broader market returns on a consistent basis.
Alternatively, investors should also be wary of the risks associated with penny stocks. Penny stocks traded in OTC markets are not required to disclose their financials and latest developments. This lack of transparency will keep risk-averse investors away, and for a good reason.
Also, these companies have a demonstrated history of hyping up their current business operations and future expansion plans, which, if not vetted carefully, can result in a “Value Trap” investment.
While a penny stock can generate exponential returns, it can also burn massive investor wealth. For example, Nokia’s stock price rose from $1.94 in July 1994 and touched a record high of $60 just before the dot-com bubble. It then touched a multi-year low of $1.8 in July 2012.
Because of the potential for volatility, investors should only allocate as much capital as they can afford to lose in trading penny stocks and avoid some of the penny stock trading mistakes described above.
Keeping the above factors in mind, investors should consider the following points in order to identify which penny stocks to buy.
4 Effective Penny Stocks Trading Strategies
1. Use Technical Analysis
Technical analysis tools highlight the potential rally or slump in a particular stock, based on historical performance and current market trends.
As it mainly focuses on extrapolating past share price data to spot any potential breakthrough, technical analysis of penny stocks is one of the best ways to identify potential winners. Some of the most popular technical analysis tools include Bollinger bands, candlestick patterns, support and resistance levels, and multi-period moving averages.
However, technical analysis does not take into account the fundamentals of a company. Thus, investors using technical analysis tools to invest in penny stocks should have a short time frame, following which they should exit their position.
2. Spot Stock Pumps
Unregulated penny stocks and pink sheets trading on the OTC markets can be bought and sold through brokers, many of whom have ties with the issuing companies. Brokers often release falsified or misleading information regarding the technical prowess or the growth potential of such companies in the market.
By “pumping” up certain penny stocks in the market, risk-loving investors throw their money into the stock, causing prices to rise rapidly. However, as the prices start rising, brokers start exiting their position, allowing them to book hefty profits on their holdings. However, the consequent price decline leads to huge losses for investors.
This is one of the most common methods through which retail investors lose money on penny stocks. In order to avoid this, investors should remain cautious while taking advice from OTC market brokers regarding trading penny stocks, particularly the ones with a sullied market reputation.
Instead, investors should look for the official statements released by the company.
3. Check Volume and Volatility
Penny stocks tend to be highly illiquid, as only a handful of people invest in these highly speculative securities. However, stocks with extremely high bid-ask spreads should be avoided, as these investments cannot be liquidated easily.
Alternatively, certain popular penny stocks traded in OTC markets have relatively high trading volume and, thereby, lower bid-ask spreads, making them best suited for investors having a large risk appetite.
Further, checking the volatility of a penny stock is crucial, as they reflect how the current market trends affect their share prices. Investors can refer to the Beta value of the stocks in order to form an idea regarding their volatility. Most penny stocks tend to have a beta of higher than 1.
Investors should avoid stocks having a negative beta, at least in the near future, as the global economy bounces back from the recession. This is because stocks having a negative beta react inversely to the current market trends.
With the global stock markets currently hovering near their all-time highs, such contra penny stocks are best avoided for now. These stocks tend to be better investment bets during times of recession.
4. Conduct Due Diligence
Penny stocks are not legally required to file their financials or the latest developments in the company with the SEC. However, many companies do voluntarily file their quarterly or annual earnings report with the commission, making them relatively reliable investment bets.
These filings are publicly available. Investors should look through these companies’ forms 10Q and 10K to gauge their financial stability.
Ideally, investors should target companies having sound operating cash flow and working capital. Also, investors should avoid start-up companies having a history of share dilution, as it reduces the value of their holdings.
Moral of the Story
Interested in trading penny stocks?
The above provides a starting point for investors willing to dip their hands in some of the riskiest stocks in the equity markets.
Picking the right penny stocks can help retail investors amass significant wealth, as these stocks can go from trading at less than $5 to being priced at hundreds of dollars. Many blue-chip companies today started as penny stocks.
Thus, investors performing due diligence regarding a target company and gauging their earnings potential can potentially identify such multi-bagger stocks. However, it’s important to also be aware of the risks inherent in trading penny stocks and take measures to shield yourself from those risks.
Now that you know some strategies to trade penny stocks, which companies will you invest in?
Tawnya is a 34-year-old Special Education teacher in the sixth year of her career. Along with her partner, Sebastian, she runs the blog Money Saved is Money Earned. Tawnya has worked extremely hard to reach her goals and remain debt-free.
She holds an Honors BS in Psychology from Oregon State University and an MS in Special Education from Portland State University and has had a pretty successful writing career, first as a writing tutor at the Oregon State University Writing Center, and in recent years, as a freelance writer.
Tawnya and Sebastian have a wealth of knowledge and information about personal finance, retirement, student loans, credit cards, and many other financial topics. It is this wealth of tips and tricks that they wish to pass on to others.