Thursday, May 6, 2010


As the name implies, Penny stocks are the stocks sold for penny which describe its low price nature. They are described by SEC as the stocks of companies that trades below the price of $5. They are the stocks of companies with market capitalization of below $200 million. They are traded in Over-the-counter market through the exchanges like Over The Counter Bulletin Board (OTCBB) and Pink sheets. This type of stock is described by its low average daily trading volume which is due to its less patronage.

Penny stocks are highly volatile stocks which has the tendency to rise or fall even above 500% in a day. This makes the stock very profitable and at the other hand very dangerous if proper risk management is not implied. This has generated a controversy on whether it is safe to invest in such companies or not. Let us look at both the advantages and disadvantages of trading penny stocks, which will help any investor going into it to know exactly what he is getting into and how to go about it.

  • Low start up capital: this encourages investors with little capital to also participate in the business of stock trading. You can buy up to 2,000 units of shares of a company selling at a price of $0.10 with only a $200 capital.
  • Advantage of high volatility: despite all that has been said about this type of stock, it did not change the fact that it is possible for an investor to earn up to 1000% ROI due to its volatility. Big companies we see today like Google, started as a penny stock but today, it is counted among the big fish. The ability of an investor to find stocks with good potentials among the penny family determines his success. This chance i must say is very slim.
  • Information problem: these small cap companies provides little or no information about their companies and its operations making it extremely risky for an investor to invest in such companies. The companies usually have no track record of financial information. They can easily change their ticker symbols or get delisted in the exchange with no notice.
  • Volatility and Liquidity problem: due to its volatility, an investor can loose almost all the money invested if adequate stop loss position is not placed. And also it lacks liquidity (i.e. trades in a very low volume) which can make the sell of the stock impossible at times because there are no buyers.
  • Manipulation problem: it is very easy to manipulate the prices of these stocks because of its very low price. These stocks can be bought in high quantity by some fraudsters who will then move to promoting the stock as the "hot stocks" through e-mails, TV, radio and other media. Immediately other ignorant investors put their money into the stock, this will make the price to go even higher due to the increased demand. Then the fraudsters will offload their own stake by selling them which will create a sudden fall in price making the later ignorant investors to loose. This activity is an illegal "pump and dump" scheme.
In conclusion, we have seen that there is a very high risk of trading this type of stock and as well a high reward if a successful pick is made. We will end by advising that an investor who wants to trade this type of stock should do it with caution. You need to research more and avoid giving-in easily to hypes. Make use of good risk management system and ensure you put a stop loss order on any open position. Some institutional investors invests very little percentage (like 5% to 10%) of their portfolio into the penny stock. So, it is advisable for you not to invest all your trading capital into penny stocks but some percentage of it.

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