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Why do people invest in penny stocks?

By Zoran Temelkov

Penny stocks are a high-risk investment but investors have the opportunity to make high returns if they invest in the right penny stocks.

What are penny stocks?

Penny stocks or penny shares are stocks of small-cap companies, or small companies in general, which trade at a price below £1 in the UK or below $5 in the USA. Commonly these stocks are not traded on the major exchanges. Penny stocks are traded over the counter (OTC) and transactions are executed through the electronic OTC Bulletin Board or the so-called pink sheets. The way in which penny stocks are available for investing or trading means that there is limited oversight and there is a lack of minimum standards which should be satisfied for a stock to be quoted. This is especially true for the pink sheets while the OTC market may impose certain requirements in terms of documentation.

Penny stocks are typically shares issued by a newly formed company or an existing company faced with certain difficulties in their operations. Moreover, with most penny stocks, there is a lack of track record and relevant data may not be available or easily found, which means that investors will not be able to make a proper analysis. The stocks are characterised as a high-risk instrument with high growth potential, which could provide a high reward. Consequently, they are considered to be a speculative investment and also you can have the opportunity to buy a substantial quantity of shares with a lower amount of capital.

The penny stocks can be highly volatile, which offers the potential for high returns but also for substantial losses. They usually have limited liquidity which means that the demand for a specific penny stock can be very limited and investors may find it difficult to sell their stocks. In addition, the spread between the bid and ask price can be wider compared to other types of stocks.

When talking about investing in penny shares, you should be aware that this type of instrument is often subject to certain scams in which honest investors have lost their money. The common types of scams associated with the penny stocks are the "pump and dump" scam and the "short and distort" scam. The objective of the scammers owning certain penny stocks in the pump and dump scheme is to inflate the stock's price and sell it at much higher, overvalued price. Scammers have the opposite objective with the short and distort scam, in which they short sell the stock at a higher price and buy the stock at a much lower price. Accordingly, they try to decrease the price as much as they can through negative marketing, spreading false rumours which can damage the company value.

How to invest in penny stocks?

Investing in penny stocks means that you should do your research and analyse different factors and make a relevant investment decision as with any other stocks. The difference is that you need to be more cautious when analysing this type of stocks as you are dealing with a new company or a troubled business.

So, first, decide the industry in which you want to invest, whether you will buy stock from a newly formed company without any history or from an established company whose stock price fell down enough to become penny stocks, etc. The decision will be in accordance with your personal preferences, but anyway, you should always have an investment strategy set in place. It can increase the probability of profitable investments and limit the number of bad investments.

Get familiar with the OTC Bulletin Board and the Pink sheets since they are a quotation service for penny stocks offering an updated quote for the stocks. The OTC bulletin board and the pink sheets represent a valid source of information regarding the movement of the stock price, which can be further used in your research. Some investors and traders look for stocks with high volume exhibiting a strong trend.

If you are ready to invest in penny stocks, find an online broker through which you will execute your transactions. Keep in mind though, that penny stocks come with a wider spread, meaning that you should pay attention to the spread and other fees charged by the brokers.

However, investing in penny stocks can offer the potential for making substantial profits but being a high-risk investment means that you stand to lose your investment swiftly. Hence, prior to investing your money in penny stocks, try to test your skills and knowledge by using a demo account.

How to start investing in penny stocks?

You can follow the next points toward your path to investing in penny stocks:

  • Understand and know how to read the OTC and Pink sheets as well as understanding other aspects related to penny shares.
  • Set ground rules and criteria which will help you identify potentially profitable penny stocks.
  • Do not fall for penny stocks being promoted as the “next golden stock”, always perform your analysis to ensure that the stock is not part of some scheme such as the pump and dump scheme.
  • Select an adequate broker and do not forget the broker’s fees and charges.
  • Set up your final penny stocks investment strategies.
  • Start by investing small amounts in penny stocks, also you may consider investing in a diversified portfolio of penny stocks. But again, you should not put too much money in this type of investment at the beginning or until you are confident enough.

Are penny stocks a good investment?

When it comes to investing in penny stocks, many sceptics would say that you should avoid putting your money in this type of investment. On the other hand, there are traders and investors, which may state that investing in penny stocks can be profitable as long as you realise how they function and develop an adequate investment strategy. In the end, the final decision whether you will invest in penny stocks or not falls upon you. Let us go through some of the major advantages in favour of penny stocks investing as well as disadvantages of this type of stocks.

Advantages of penny stocks

  • The potential for making substantial profits, it should be noted that there are penny stocks which have brought a profit in excess of 1,000 per cent to its investors.
  • You do not need to have large capital to invest, penny stocks allow you to invest a smaller amount of money and yet make a satisfactory profit.
  • Opportunity to purchase a large number of shares (and ownership) from a company for a lower amount of money.
  • Pay a low price for a company which can grow into a highly profitable and successful company.
  • Higher volatility can make an opportunity for some quick profits (or losses).

Limitations of investing in penny stocks

  • Most often penny stocks come from unknown or low-quality companies facing financial difficulties or problems in their operations.
  • Although investors do make money by investing in penny stocks, it is said that the majority of investors end up losing money.
  • Very low or maybe non-existing listing and reporting standards for a stock to be included in the OTC or the pink sheets which offers an opportunity for low-quality companies to try to raise funds.
  • Higher fees and commissions set by brokers.
  • Limited liquidity can create problems when you want to sell your stocks.
  • The occurrence of scams related to penny stocks.

FURTHER READING: Alternative investments: much more than fine wine and baseball cards

FURTHER READING: Three ways to make money with stock index investing

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