The Risks of Trading Penny Stocks
Penny stocks are securities that trade below $5 if you’re in the US or $1 if you’re in the UK.
Due to the inexpensive nature of penny stocks, its appeal to beginner traders is staggering. It does look very promising to traders whose limited funds hinders them from playing in the stock market and even for those who just wants to get the “feel” of trading. Some are into it in the hopes of finding and investing in the next big thing. While we do not completely reject the possibility of becoming successful through penny stocks, the possibility though is slim.
Here are 4 reasons why pinning your hopes on penny stocks can leave you wincing in pain, literally and figuratively:
1. Limited information made available to the public
Companies are not listed on a national exchange. In fact, they are not required to file with the Securities and Exchange Commission. Therefore, unlike the stocks listed in New York Stock Exchange and Nasdaq and, with the limited information available, public scrutiny and regulation are not possible. With no or limited information available, it would be difficult to make intelligent or informed decisions about the market.
2. No minimum standards are required
Minimum standards are required to protect the investors as well as the companies. However, with companies involved in penny stocks, they are not required to meet the minimum standard. They’re also not required to file documents at the Securities and Exchange Commission. Given this circumstance, your money has no protection whatsoever.
3. Lack of company history
Most of the companies that get into penny stocks are either new or are about to go bankrupt. So they either have no or zero track record that you can look into if you want to find out its potential. Buying a stock from a company that provides little or zero information about their company is downright ridiculous. You won’t typically entrust your money to strangers, won’t you?
4. Problem with liquidity
First off, there are not enough players in penny stocks. Secondly, there are players, big investors, who may manipulate stock prices to their advantage. So basically, you may end up buying penny stocks that are rallying up only to find out too late that stock prices have gone down because investors already sold all their shares.
This is known as the pump and dump scheme. As a result, you are either forced to hold on to a losing stock because nobody’s interested in buying it or sell it at a much lower price than when you bought it. This is a product of the dynamics of low liquidity in penny stocks. Investors have uncanny ways of manipulating stock prices and you are at their mercy.
In as much as it’s financially favorable to you to get into penny stock trading, given the evidences presented to you above, penny stock will just eat up your fund thereby not making it a worthy investment.
Due to its nature, a lot of fraudsters get into penny stock trading. One of the most common practices is biased recommendations. It’s when certain individuals recommend a particular stock either through newsletters, emails, radio ads or TV shows. They are either paid for by the micro-cap company or they have a share in that stock they intend to get rid of.
They’re recruiting buyers because the stock price is about to take a plunge and they don’t intend to stay and watch it splatter and splash. Therefore, any piece of advice from anyone should be taken with a grain of salt.
Many huge companies listed on New York Stock Exchange and NASDAQ did not start out as penny stocks. Many beginner traders have this false notion that large companies started out as penny stocks, thus the hunt for the next big thing. It’s not always true.
Also, traders get into penny stocks because they believe that there are more room for appreciation of stock prices and that it also provides them an opportunity to trade more stocks in bigger shares.
Although the latter is true, because you have more buying power due to the cheap stock price, the former isn’t always true. Although a stock price can increase by 50% or 100%, it can also decrease by 50% or 100%. And given the volatility and low liquidity of penny stocks, you may end up losing money.
So, is it safe to trade penny stocks?
I say, given the circumstances presented above, no it isn’t. But let me just clarify that penny stocks are not a lost cause. There are still good quality companies out there that work hard to get to the big leagues.
Although the stock is very cheap, the returns are consequently low, making it unworthy of your time and effort. Penny stocks in general are high-risk investments that beginner trades should, as much as possible, try to avoid. The best advice one can give you if you are really keen on trading penny stocks is to do an extensive research first. Make sure you understand the benefits and the risks of getting into it.
Copyright (c) 2013 Thembi Buthelezi