Penny Stock Definition & Example


What is a penny stock?

A penny stock is a share that costs somewhere between a couple of pennies to about five to ten dollars. The traditional notion of a penny stock is often a smaller company that is usually traded on smaller lists, has lower liquidity, lower market capitalization, is more difficult to obtain information about, whose share is easier to manipulate and which sometimes has a reasonably speculative business idea, perhaps in a new and exciting industry.

Good to know about penny stocks & example

Many times the share is a so-called High Risk, High Reward which either develops into a price rocket if the business idea strikes well, or stays / drops to the level of around a few pennies per share, or in the worst case goes bankrupt or is delisted from the list.

There are examples of shares that in the 2000s have cost as little as 0,001 dollars.

A company likes to avoid their shares ending up in the penny stock class, precisely because of the above-mentioned reasons and negative associations.

Is the penny stock label negative?

Of course, a company prefers that the share is valued more than a penny and at the same time it is also difficult to be attached to a cluster of companies with which it is easier to manipulate the price.

However, what can be positive for a company whose shares cost $0,05 each is that they can be extra interesting as more people can buy shares for cheaper money.

Therefore, it is not required that they should increase so much for the price of the company to go up several hundred percent.

But remember that there is also a reason why stocks are actually so cheap.

Potential benefits of investing in penny stocks

As with other equity investments, there are advantages to trading shares in smaller companies. This is despite the high risk involved in investing parts of their share capital in this type of company.

Many of the regulatory bodies around the financial markets place great emphasis on pointing out the risk of trading small companies at a low price, but they are not as interested in talking about the upside.

Therefore, here are a number of benefits.

1. Availability

Thanks to the unit price, penny stocks are easily accessible even to smaller investors. No large amount is required to start trading in shares from smaller companies.

A couple of hundred dollars, or in some cases the rattle of the piggy bank, can constitute an acceptable start-up capital.

In order to trade the more well-established shares, greater efforts are generally required. Thanks to various online stockbrokers, such as Robinhood or Webull, you can start trading without investing your entire fortune.

In other words, as a small saver, you do not have to worry about having enough money to be attractive as a customer of a hedge fund or other institution.

Instead, you can buy small companies with low prices.

2. Low Price

Perhaps the main advantage of trading penny stocks is that they have a low unit price. Most shares cost much less than the arbitrary limit corresponding to $1 per unit.

This makes it easy to buy a large number of shares with a small amount of money.

3. Rapid Price Changes

The change in value of a share of this kind can be rapid. Significantly significant price changes can often appear in just a few days, sometimes hours.

It is not uncommon for the value of a penny stock to change by 50, sometimes even 100, in just one day.

This means that you who invest in penny stocks you can quickly make money.

Several experts argue that this type of stock is best suited for day traders. A common attitude is that you do not buy and keep a penny stock, but it should instead be seen as a short-term investment.

4. Enormous Potential Return

Another great advantage of trading penny stocks is that the potential return is really high. Even a small saving invested in the right stock can make you rich with a little luck.

The fact that shares of this nature are often cheap, in absolute terms, can be advantageous. If a test result is positive, or an analyst runs the stock, the value can often double or increase more than that.

5. The Large Company of the Future

In some cases, penny stocks succeed in establishing themselves in their respective markets to an extent that results in sales in the company growing.

In some cases, the growth is so marked that they establish themselves on larger lists. Thus, the return can really take off, in a sustainable way.

This is the way most companies establish themselves in today’s business climate.

Most companies that we today think of as large and well-established have undergone the same journey.

Dangers of investing in penny stocks

As you have probably heard before, investing in penny stocks is not risk free. It is easy to be fooled into buying many shares in smaller companies, as you can buy them for a small amount.

However, it is associated with great risk. Read on to learn more, and avoid falling into the trap.

1. Low Liquidity

The number of outstanding penny stocks can be very low. In the vast majority of cases, larger investors such as hedge funds and pension funds are not interested in them.

This means that it can be difficult to sell them, more difficult than to buy. It is not an exaggeration to argue for penny stocks as a buyer’s market.

As a salesperson, it is not uncommon for you to have to sell at a lower price than you first thought. This can lead to business ending in red numbers.

In addition, due to the low liquidity, the actions of an individual player can greatly affect pricing.

The low liquidity is extra important to keep in mind if you intend to trade penny stocks with a short time horizon. For example in day trading.

2. Lack of Information

Information is the basis of a good investment. To make a good investment, you need to read about various key figures in the company that you are researching.

But in smaller companies, especially unlisted ones, it can be difficult to access important data. And even if you were to get your hands on information about the company, it is important to question how reliable it is.

If you are daring and want to invest in off-exchange companies, you should keep in mind that these companies are less regulated than comparable companies on the stock exchange.

Nasdaq place strict demands on their listed companies. So if you want to trade in penny stocks, consider starting there rather than with unlisted companies.

3. Loose Background

Penny companies are often young companies whose history can be difficult to discern and investigate. In some cases, the penny companies are close to bankruptcy and have issued shares as a last resort to survive.

The combination of lack of historical data and potentially questionable quality regarding available data makes it difficult to assess long-term profitability.

4. High Volatility

As you have probably calculated by now, the low liquidity has a strong impact on volatility. Low liquidity leads to high volatility.

A major player who takes a stand on a penny stock can change the price significantly. This explains why the graphs that show the value development of small companies sometimes resemble roller coasters.

Volatility also makes it difficult for you as an investor to predict the price.

Add to that the fact that there can be big differences between the buy and sell price in the market. This is due to the limited number of investors trading the shares.

In addition, this difference may contribute to higher transaction fees.

But there are further reasons why the price changes of penny stocks can be large, namely rumors of, for example, fraud.

5. Lack of Regulation

Companies that are not listed on any stock exchanges are less regulated than their counterparts in the public trading venues.

In order to be accepted at Nasdaq, statutes and rules must be complied with. The same does not apply to companies that are traded unlisted.

It is worth keeping in mind, as the regulations are primarily there to protect you as an investor.

6. Trading happens for speculative purposes

As there is a shortage of raw data, much of the trading that takes place in penny stocks is pure and simple speculation. In some cases, it is not even clear what type of product the company is selling.

It can be repeated, most people who trade with penny companies speculate to make big money, fast.

7. Easy to manipulate

Since unlisted companies are loosely regulated, it is relatively common for them to be fraudulent companies.

Therefore, you should think and examine both once and twice before including an unlisted company in your equity portfolio.

Common examples of scams with Penny Stocks

There are many methods that fraudsters use to deceive small savers. Below are some of the most common methods.

1. Systematic Dilution

A company runs a fraud project by systematically issuing new shares. The new shares are issued without any underlying rationalization, except to take money from investors.

Thereafter, the number of shares is converted through a reverse share split and the number of outstanding shares decreases.

2. Pump And Dump

This method is based on the share price being manipulated through a large purchase of shares. The share is then hyped in various channels, such as online forums.

This means that demand increases, which leads to rising share prices.

When the price reaches the desired levels, the fraudsters sell their shares with their profit. The small savers are left with a touch of worthless shares.

3. Self-appointed Expert

A self-appointed expert presents a strategy that is said to be masterfully adapted to penny stocks.

In exchange for your money, he offers to pass on his knowledge to you. In other words, he is selling a course. This type of fraud also occurs in currency trading.

4. Marketing shame

An equity broker buys a large batch of shares from a major shareholder in an illiquid share at a discount. By marketing the share aggressively via its own platform, the equity intermediary forces a price increase.

The price increase is driven by increased demand as a result of marketing from the stockbroker.

When the shares are sold to the equity intermediary’s clients, they are well aware that the share is in fact overvalued.

How to trade penny stocks

There are two approaches to successfully trading stamp shares.

  • Short-term trading
  • Investment with a long time horizon

Invest with long time horizon

Buying and retaining penny stocks with the goal of achieving long-term returns is certainly not easy. But if you score correctly, you will be richly rewarded.

But it requires that you are dedicated to the task.

To identify the right company, you need to read about everything. The board, the product, is there a demand for the product and is it a competitive market?

In addition, you must familiarize yourself with the company’s historical achievements. What does the cash flow look like in relation to the previous year and other key figures.

This document is intended to understand how far the company has the opportunity to be profitable in the long run or not.

If you find a penny stock that you want to invest in, you can do it through a broker. But remember that no matter how bright your vision of the future is at the company, do not put all the eggs in one basket.

Short term trading

When you shop with a short time horizon, you try to buy and sell to capture price movements. You can trade in both directions, ie both ups and downs.

However, remember not to hold a position for too long. When your predetermined exit level is reached, sell and take home the profit.

Short-termism is the most common approach when trading penny stocks. Technical analysis is often used to find opportunities to invest.

Conclusion

Investing in penny stocks is associated with high risk. But if you understand how they work and have a healthy attitude towards them, there is money to be made.

When you think about it, you quickly realize that all investments involve risk, penny stocks as well as well-established shares.

With that said, it is not a good idea to invest all your share capital in penny stocks. If you are looking for a long-term and stable return, you can read up on index funds.

Still feeling unsure on what to do? Then watch this video I found on Youtube:

Sources

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https://www.journals.uchicago.edu/doi/abs/10.1086/380387

https://link.springer.com/article/10.1007%2Fs11187-009-9190-x

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https://books.google.se/books?hl=en&lr=&id=SSeO3vNl5vgC&oi=fnd&pg=PA1&dq=Penny+Stock+&ots=IjVKAub3zX&sig=uw8Zd64EDeESZT9z2rSnUbrCWX0&redir_esc=y#v=onepage&q=Penny%20Stock&f=false

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1460979

Kevin

This article has been reviewed by our editorial board and has been approved for publication in accordance with our editorial policies.

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