Penny stocks are some of the most talked-about forms of equity investments, as they tend to generate the highest returns compared to other securities. These stocks are typically priced below $5 and are traded over the counter. The underlying companies are generally in their development stages, allowing investors to capitalize on their business expansion.
Given their tremendous growth potential, penny stocks are often called multi-baggers. However, as such companies tend to be relatively unknown, investors should thoroughly examine a penny stocks trading guide to understand the potential risks and maximum return generating capacity before investing. Let’s also take a look at a few important features of penny stocks.
Low Bid-Ask Spread
Penny stocks have low trading volumes as they are lesser-known companies and might trade over the counter. As a result, it isn’t easy to find appropriate buyers or sellers of penny stocks in the secondary market, as the bid price on such shares tends to be different from the ask price.
Given the illiquid nature of penny stocks, investors might find it challenging to exit their positions at any time, as the markets don’t have the required number of buyers. Thus, investors should plan their investments accordingly to consider the liquidity risk associated with such stocks. The share prices are updated on the OTC Bulletin Board (OTCBB).
Traded OTC
Over-the-counter trades are unregulated, therefore giving speculative companies scope to enhance their fundamentals to appeal to investors. Most penny stocks are traded in the OTC markets, as they don’t fulfill the requirements of regulated exchanges such as Nasdaq or S&P 500.
Often, brokers pump the prices of such penny stocks by circulating misleading or false information, allowing intermediaries to book substantial profits from the trades, following which they exit the markets. This causes the prices to plummet, thereby resulting in extensive losses for retail investors.
Pink Sheets – A Type of Penny Stock
Pink Sheets are traded through broker-dealer networks and have lower supervision compared to penny stocks monitored by the OTC Bulletin Board (OTCBB). These companies have no legal requirements to disclose their financials, as they need to file Form 211 with FINRA to trade over the counter.
Even after trading on a lesser-known exchange, these companies are not required to file their annual statements with the Securities and Exchange Commission (SEC), making them highly speculative.
Pink sheets tend to trade at lower prices compared to penny stocks. However, given the lack of information and practically no regulation, these companies seldom become profitable investment bets. Also, given the gigantic risk associated with pink sheets, these tend to be illiquid, with extremely high bid-ask spreads. As brokers sell these shares through pump and dump schemes, pink sheets frequently cause fraudulent scams.
High Risk
As stated above, companies issuing penny stocks are not required to disclose their financials accurately or report each recent development, as they are not monitored by the SEC. Thus, such lesser-known companies often inflate their financials and future growth potential to attract investors. This, coupled with the high bid-ask spread, make penny stocks some of the riskiest equities in the market.
However, the high risk is compensated by the potential to derive market-thumping returns. These lesser-known companies offer unique products and services, which often have the potential to disrupt respective industries. Investing in such unicorns at an early stage should allow investors to amass substantial capital gains, especially if the company can beat consensus estimates consistently.
High Volatility
Penny stocks have beta values of more than one, indicating substantial volatility. It is because small-cap companies perform well when the markets are rising, leading to higher demand and surging investor optimism. During periods of economic boom, investors tend to assume higher risk and make penny stocks an attractive choice. The rising aggregate demand allows underlying companies to witness higher sales and rapidly improving profit margins.
However, in a market downturn, penny stocks generally lack adequate cash balance and liquidity to stay afloat as their financials plummet. With negligible revenues, such companies have to close shop as they fail to generate the minimum revenues required to make timely interest payments on debt.
Federal governments worldwide may offer substantial protection to small and medium-sized enterprises during times of economic recession. The United States launched a $2 trillion CARES Act in March 2020 to facilitate small companies to remain in business as global economies shut down. The United Kingdom launched a similar Coronavirus Business Interruption Loan Scheme (CBILS) to preserve the interests of SMEs during the initial stages of the pandemic.
Alternatively, the pandemic was a once-in-a-lifetime event, and governments may refuse to provide such support in future downturns.
Bottom Line
Penny stocks can be immensely profitable if traded carefully with proper background checks on underlying companies. All of the biggest names in the stock markets started as penny stocks decades ago and are currently valued in over trillions of dollars. However, investors should be aware of their risk-taking capacity and future financial needs, as these investments tend to be illiquid and volatile.