Common shares of small companies that trade at low prices are often referred to as penny stocks. (By small companies, we mean nano cap or micro cap.) There is no legal definition of the term “penny stocks”, so different investors can have different ideas about exactly what constitutes a penny stock. Generally speaking, it is stocks with low market capitalization, low liquidity and large bid-ask spreads that get the label penny stocks.
A common misconception is that only stocks traded over-the-counter (OTC) can be considered penny stocks. In reality, there are a lot of examples of exchange traded stocks that tick all the boxes for penny stockiness.
It is common for beginner investors with small bankrolls to be attracted to penny stocks. Penny stocks tend to be highly volatile, and while this is one of the reasons behind their appeal it also means that they are really high risk. So, if your bankroll is limited, you might want to consider putting a majority of it in safer stocks (e.g. blue chip) and only penny stock gamble with a smaller part – unless you really love high risk investments.
It is easy to understand why penny stocks are appealing. When we see a penny stock prize rise by 40 points in 48 hours, it catches our attention. When one has a small bankroll to invest, spending it on a very small number of high priced blue chip shares and wait for them to gradually increase in prize over months or years is not as fun and exciting as buying a whole bunch of penny stocks and watch them do their crazy super-volatile moves. Of course, a stock prize that can easily go up by 40 points in 48 hours can just as easily drop down by 60 points in the next 48 hours.
- Cent stock
- Penny share
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A common misconception
A common misconception regarding penny stocks is that all the companies that are high-priced blue chip stock companies today once upon a time started out as penny stock companies and then gradually increased in value.
In reality, a lot of companies enter the stock market far above anything that could be seen as penny stock level. Microsoft did for instance trade for well over $20 on its very first day of trading, and so did Wal-Mart. If you look at the adjusted stock price for Microsoft on its first day of trading it will say $0.09 but that is because an adjusted stock price takes later splits into account. Microsoft never traded for $0.09.
The misconception is eagerly fanned by plenty of “investment advisors” that wants to convince you that the penny stock companies that you invest in today are destined to be the equivalent of Apple and IBM within a few years.
Factors that contribute to the volatility of penny stocks
- The companies
Penny stock companies are often (but definitely not always) newly formed companies. With new companies, you don’t have a lot of historical data to use when you analyze the company. Investors are forced to rely heavily on other methods, e.g. studying the history of core staff.
Also, many of the penny stocks that are traded over-the-counter (OTC) are in companies that does not fulfill even the minimum requirements of any of the major exchanges. If they applied for listing, they would be turned down.
- The low liquidity
Penny stocks tend to have low liquidity. An investor that really wants to sell right now might be forced to accept a super low-ball offer – especially if she want’s to get rid of a large amount of stock. Now, a large amount of stocks has been sold for a really low price, and this impacts the market prize. It is not unusual for penny stocks to need quite a lot of time to bounce back after a sell off, even when the sell off had absolutely nothing to do with how well the company was doing.
- The investors
Investors that deals in penny stocks are often day traders or other short-term speculators. They keep a keen eye on the stock prize and do not see their stocks as long-term investments. Their behavior contribute to the volatility of penny stocks.
It should also be mentioned that stock price manipulators tend to be fond of penny stocks. You don’t need a lot of capital to purchase a lot of penny stocks and then carry out a pump-and-dump or other scheme. The low price of the penny stocks also makes it easier for these manipulators to convince people that don’t normally invest in the stock market to purchase stocks.