Pros and Cons of Penny Stocks

  • Kanan Arora
  • Jul 26, 2021
  • Financial Analytics
Pros and Cons of Penny Stocks title banner

Introduction 

 

As suggested by the name, penny stocks refer to the stocks that are traded in pennies. Such stocks constitute a significant number of the stocks being traded in the stock markets and form an exciting domain to spot ‘multi baggers’ or stocks that multifold over a certain period.

 

Most of the penny stocks belong to companies with a relatively smaller market capitalisation; these include smallcap companies with a market capitalisation between $ 2 billion and $ 300 million, microcap companies with a market capitalisation between $300 million and $50 million and even smaller companies. 

 

These companies provide splendid growth opportunities and can deliver unreal returns if held for a sufficient amount of time. Several instances are there in which people have compounded their wealth, owning companies that eventually became large-cap.

 

Buying penny stocks can be visualised as purchasing lottery tickets. However, some aspects of this lottery can be analysed using technical analysis and fundamental analysis techniques. So an investor can establish the approximate probability of success, i.e., the stock multiplying by several times. This probability then guides the allocation of that particular penny stock.

 

Generally, the probability of success in the process of selecting adequate penny stocks is extremely low. Several traders and investors target penny stocks by allocating a small portion of their portfolio to the segment.

 

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This blog analyses the various pros and cons of investing in penny stocks and seeks to establish the essence of investing in penny stocks.

 

 

What are the Pros and Cons of Penny Stocks?

 

Listing below the pros of penny stocks;

 

  1. Low Share Price: 

 

The evident advantage of investing in penny stocks is that they are worth pennies, and therefore, even small amounts of money can be invested in these stocks. 

 

The price of a share of Warren Buffet’s Berkshire Hathaway is more than $400,000, a majority of the investors worldwide would not be able to afford even one share of Berkshire Hathaway, but they have the opportunity to buy thousands of penny stocks with less than 1% of the same capital.

 

 

  1. Possibility of multiple returns

 

The most significant edge provided by penny stocks is that they have the opportunity to grow rapidly. Penny stocks offer a great way for retail investors to compound their initial capital, and quite a few highly acclaimed great investors today have been blessed by penny stocks in one of the previous bull markets. 

 

Due to a lack of liquidity, institutional investors can not capitalise on penny stocks as much as retail investors. In a way, penny stocks provide retail traders with an edge over institutional traders but with a significant risk associated. 

 

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  1. Short Term Volatility

 

For traders operating in the shorter term, penny stocks provide a great way to capitalise since they are much more volatile (or have high betas) than their larger counterparts. 

 

The probability of a stock hitting a circuit breaker (a regulatory halt imposed on stocks that have moved past a threshold percentage on a particular trading day), either the upper or the lower one, is much higher for a penny stock. This, however, can prove to be counterproductive as well. 

 

In situations where the lower circuit or the upper circuit is being hit continuously for a couple of days, it becomes impossible for traders to exit their positions, causing them huge losses. This type of unexpected event needs to be considered before making allocations in penny stocks.

 

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Following are the cons of penny stocks;

 

  1. Low Liquidity

 

Since penny stocks belong to small companies, they do not capture sufficient investor interest in the markets. Most of the interest in penny stocks is retail interest, and only when stocks start gaining in market capitalisation, institutional interest might come in. 

 

Low institutional interest and high network individuals’ interest in penny stocks can be attributed to their low market capitalisation in the markets. Market participants with huge sums to invest want high market capitalisation stocks so that the markets can absorb their money and their orders can be executed at a particular price or in a particular price range. 

 

They do not want to end up being the only buyers for a specific penny stock or not being able to cash out in profits due to a lack of buyers. Often, the total market capitalisation of a penny stock might not even satisfy the minimum amount for institutions. 

 

  1. Price Manipulation

 

Penny stocks can move tremendously since they usually belong to very low market capitalisation companies. Any high network individual or institution can easily sway the price of a penny stock by purchasing a sufficient amount of shares of that stock and further reducing the number of shares left for trading. 

 

In other words, any market participant with enough funds can manipulate the price of penny stocks by decreasing the supply or increasing the demand of those stocks. 

 

There are many instances when the prices of penny stocks are artificially inflated and then dropped; market participants with big money might indulge in such pump and dump schemes to profit off small and uninformed market participants. Thus, a risk of being manipulated is always there in penny stocks. 

 

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  1. Lack of information and asymmetric information

 

There is an information risk inherent to penny stocks. Since there is both- a lack of information and asymmetric information involved with penny stocks, it becomes difficult for investors to make informed decisions while dealing with such stocks. This is why risk management becomes even more essential while investing in penny stocks.

 

 

  1. Loss of capital possible

 

A complete loss of capital deployed is possible with penny stocks since they belong to small companies. Small companies are the most prone to bankruptcy in instances of financial distress. 

 

Even though there is a possibility of default in large-cap and mid-cap stocks, the probability of default in such stocks is low, and even if there is a default, the loss given default is rarely 100%. Because there is a possibility of complete loss with penny stocks, an investor should limit the exposure in such stocks to risk capital. 

 

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An investor should consider the pros and cons discussed above before entering the intimidating penny stocks’ sphere. Suppose an investor has some sort of insider knowledge or other such informational edges. In that case, it is an entirely different story, in which case the probability of success would increase accordingly. 

 

But in general, there is a tiny probability of success involved while investing in penny stocks. This probability should be arrived at by technical and fundamental analysis, and an investor should decide the exposure based on pro-con analysis. 

 

(Related blog: Fundamentals of Technical analysis)

 

 

Final Note

 

Penny stocks are cheap assets that possess a significant amount of risks. There is a thin line between gambling and informed investing while dealing with penny stocks, and that is where risk management plays a critical role.

 

The stocks of large-cap companies are not worth pennies, and they require a certain amount of monetary commitment. Still, they are much safer than penny stocks, and that is why most of an equity portfolio consists of large-cap stocks, and a relatively much smaller portion is allocated to penny stocks. 

 

There is, however, no guarantee that a large-cap or a blue-chip company will deliver a definite return (as is the general misconception), and all the stocks, be it those of large-cap companies or micro-cap companies, are subject to the same market risk.

 

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In any case, stocks are risky assets; investing in bonds or currencies is much safer than investing in stocks. Even in stocks, penny stocks form the most dangerous category and thus, need to be invested in with even more caution and proper risk management procedures in place. 

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