Many people chose to buy penny stocks due to the potential profits of picking the right stock and having it pay off big. However, knowing the risks of these types of stocks is critical. Because if you don't know the risks, chances are you will lose money!
When we talk about penny stocks, it's a good idea to first define what qualifies as a penny stock. While most people would probably consider any stock priced under $1.00 to be a penny stock, there are almost as many investors and larger funds that consider any stock priced under $5.00 to be in penny stock territory. So for the sake of this discussion, we'll use $5.00 as our cutoff for what we'll refer to as a penny stock. With that in mind, here's some factors that can influence (or increase) the risks of penny stocks that you may not find in stocks that trade at higher prices:
1. The stock exchange
Is the stock listed on one of the exchanges? Buying a stock on one of the exchanges is less risky than trading stocks over-the-counter. In other words, it's much easier for "sketchy" or questionable companies to get listed through OTC pink sheets than the three major exchanges. The NYSE, NASDAQ and AMEX all have tougher requirements in place to get listed, as well as rules for financial reporting and market capitalization, among others. Any company that falls out of compliance is booted off the exchange if not brought back into compliance.
2. Trading volume
How much trading volume is there each day? If not many shares are traded in the particular stock, this can make buying and selling the stock at a market price very difficult and can increase the risk of losses. For example, if you want to sell 100,000 shares of a stock with a last trade of .10 cents but the closest best bid with that many shares is all the way down to .06 cents, you may end up losing 40% if you need to sell the stock right then. This is sometimes called "liquidity risk" and although it can be a risk of higher priced stocks as well, it is not as pronounced as in penny stocks.
3. Stock price
Why is the stock a penny stock in the first place? The price of the stock itself is important, because many times the reason a stock is trading for such a low price is the company itself may be having financial problems or other issues. The company may even be on the verge of bankruptcy. Can you be sure the company isn't going to fold the day after you buy the stock? It's a good idea to check recent news and press releases for the company to make sure there's no suprises you aren't aware of.
4. Volatility
Is there much historical volatility? And what I mean by this, is if you look at a 1 year chart for the stock does it make big price moves often, either up or down? While volatility can be your friend, it can also be your worst enemy. Imagine buying a stock for $1.00 a share, and having it fall to .30 cents in just a few days. That's a big loss, especially if you've put a lot of money in one stock.
5. News, information and research
Since the bulk of penny stocks tend to be smaller, lesser known companies, it's sometimes hard to find any information about them. The company may rarely (if ever) release news about company developments, it's products or general business conditions. This makes it very diffuclt to do research or decide if it's a company worth buying stock in. And this increases risk.
6. Location of the company
Given all these other factors, one additional thing to consider is where is the company located? Since the US, Canada and the UK tend to have more securities laws and regulation in place to discourage fraud, corruption and other unethical business practices, other countries may not, or if they do they may be loosely enforced. Buying stock in a small, unknown company in the US may be risky enough, but buying stock in a small, unknown company in Russia or some other country that may not be subject to the business or securities laws of your country can increase the risks exponentially. And just to be clear here I am not picking on Russia, I love Russia and I love Russians, they are some of the smartest business people out there - I only use this as an example to make a point.
What do I think?
Overall I think penny stocks carry higher than average risk, so I would not invest a lot of money in these types of stocks. However, if you are a person who is interested in penny stocks and think the risk is worth the potential big gains, just be sure you fully understand the risks and take steps to mitigate them as much as possible. Good luck!
Author Resource:-
John Merritt is an active investor and founder of invest.us, which offers resources for investing in America. Visit us for more investing basics, or link to this article on penny stock trading.
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