The Major Risks and Rewards of Buying Penny Stocks
To achieve success with low-priced shares, you need to be mindful and have a clear knowledge base in order to avoid common pitfalls – which can ruin your financial plans and leave you penniless. It's important to remember that most penny stocks are companies with small market capitalizations (below $100 million), have a low stock price and a high level of volatility that can act as an impediment to successful investing strategies. That means picking the right penny stocks to invest in can be one of the most potentially rewarding-and-risky types of trading an investor can do. Every effective penny stock trader will tell you that.
Below is a list of potential risks and rewards associated with penny shares. If you are serious about creating an online day trading career, you should familiarise yourself with these before doing so.
The Lowdown on Penny Stocks: Price Manipulation, Lack of Liquidity, Regulation
1. Pump and DumpPenny stocks serve as a perfect vehicle for traders, scammers, or fraudsters seeking to profit from artificially inflating the price of an owned stock through false and misleading statements. This is typically done through the use of targeted email campaigns, fake news releases, comments on message boards, or any other similar telemarketing funnel.
The scheme is referred to as "Pump and Dump" (P&D); its promotors manipulate and take advantage of traders’ interest in “extremely compelling” stocks for their own benefit.
The reason this is possible is because of the low price of the stock and lack of readily-accessible information about its market performance. Once the share price has gone up, the scammers will immediately close their positions, the stock’s price falls and investors lose their money
2. Short and DistortThe opposite scheme of Pump and Dump, Short and Distort involves short selling a stock and then spreading fake news or lies about the company in an attempt to send the stock price down. If the stock price declines, the scammers use the proceedings of their initial sell position to buy a larger number of the company's shares, in what is known as “going short”. Other investors who get tricked will either lose their money by trading-off existing shares (in an act of panic), or by following suit, i.e., opening short positions on the stock to profit from its decline, but in reality, they seldom do.
3. Liquidity – A Double-Edged SwordOn the plus side, liquidity – the availability to buy or sell a company’s stock – helps the functioning of the market in normal conditions as participants can easily find sellers for their stocks when they want to buy and buyers when they want to sell. On the negative side, in small value companies such as penny stocks, liquidity can end up being scarce – especially when you need it the most – and, as a result, selling positions is much harder. Plus, generally speaking, unsteady liquidity can cause drastic changes in a stock’s price and create harm its overall cost competitiveness.
4.Unregulated Electronic Equity ExchangesMost penny stocks trade in over the counter (OTC) markets as pink sheets. They’re not regulated and therefore are not obliged to basic financial trading rules and regulatory requirements.
This makes it easier (and quicker) to enter a trade, on the one hand, as you only need a reliable internet connection, some free time and money to invest.
On the other hand, OTC trading naturally adds risk and lack of security to your funds. Therefore, when trading in OTC, we highly recommend to stick with this rule of thumb: Only use FCA regulated brokers.
This will ensure the perfect combination of quick and safe online trading. Check out Fortrade’s trading arena for an example of a trusted and reliable broker that allows you to trade stocks, indices, forex pairs, commodities and more.
The Upside: Small Initial Investment, Plus 200% ROI Potential
1. A Beginner's FavouritePenny stocks are attractive investment avenues for first-time investors as they are sold at a low price of less than 5 dollars. This gives novice traders the chance to explore potential market opportunities with a small amount of money: less than $100, the minimum initial deposit required by most online brokers). If the stock tumbles drastically in a long position, or skyrockets in a short position, the losses for the investor will still remain relatively small.
2. The Only Way To +200 Percent ReturnsThe reason the penny stocks trading sector is so lucrative is that it offers an exceptionally high return on investment (ROI), reaching as high as 1000 percent annually. It is a common thing for penny stocks to double or triple in price value in a short period of time, whilst blue-chip stocks typically have a steady market capitalisation and one-to-two-digit growth rate. As a result, even a 200-dollar investment can turn out to be quite profitable. That coupled with a nearly endless pool of stocks to choose from (there are 1000s of penny stocks just in the UK), help explain the hype that surrounds this emerging market.
3. Keeping An Eye On Potential Gold MineWhen something is very difficult to find it’s like looking for a needle in a haystack. When it comes to penny stocks, this could be either an advantage or disadvantage. Investing in individual stocks is a skill, which, like any other, takes time and patient to develop. The extent of success rests on one's willingness to research and consider the best alternatives over various time frames (days, weeks, months, years). We believe it is far wiser to focus your resources and efforts on penny stocks instead of the major stocks that are scrutinised and valuated on a regular basis. In reality, the sweetest penny stocks often fly under market analysts’ radar and go unnoticed to masses.
Despite many advantages of trading penny stocks, there are also many disadvantages. Whether it’s the growing threat of online scammers, risks related to the OTC markets and unpredictable price volatility, or the unparalleled liquidity problem, this form of trading is surely not fit for all. Our suggestion is to go for simplicity over excitement. If you’re looking for a trusted trading environment and high profit potential, our suggestion is to sign up an account with Fortrade – a leading Forex and CFD broker based in London. You can watch their intro video for a quick overview of how this works, and read more about their advantages.