5 Things to Consider Before Investing in Penny Stocks
Investing in penny stocks offers an attractive opportunity to make money if the stock delivers according to the promise. However, there is a general assumption that only blue chip companies are good to invest in. This is a myth because most stocks were first smaller before they became as big as they are today. Investors chose to invest in them while the companies were still small and they have lived to witness the benefits of putting trust in penny stocks.
Due to the success of past companies, several other micro-cap stocks have emerged and they often come in the market with the promise of products that could pay off big time in the near term horizon. Biotech micro-cap stocks are particularly popular with this but not all of them end up delivering according to their promises. In most cases, micro-cap stocks fall under the class of penny stocks because of their tiny market capitalization, which subjects them to low price per share.
According to the Securities Exchange Commission (SEC), a penny stock is a stock that trades at a price below $5.00. However, different analysts have different thresholds for determining a penny stock with some declaring any stock under $3.00 per share under the category while others actually go for the below $1.00 price tag.
Due to their affordability, many investors and especially those that do not have a lot of money to spend on the blue chip stocks tend to prefer penny stocks. However, before making that decision, here are five things you need to consider before investing in penny stocks.
Investing in penny stocks requires thorough research
The principle of general investing is that research and identification of undervalued stocks are the keys to success.
However, investing in penny stocks can often require a lot more than just normal research. This is because, with penny stocks, there is barely information available about the stocks that you intend to invest in while the little that is available could well be mere promotion rather than the real story.
As such, before investing in penny stocks, it is important that you do your own independent research rather than relying on information already available in the public.
Penny stocks have liquidity issues
Investing in penny stocks may offer a lucrative opportunity to invest in a company while it’s still small and therefore, benefit as it grows, but when it comes to selling, it might be a lot harder than selling a blue-chip stock in the market.
This is because most penny stocks have liquidity issues. Since they are thinly traded, it might take some time before you are able to find a buyer for your stake when you decide to sell your holding, let alone finding a buyer for the right price.
Differentiate between genuine volume and fake volume
Before investing in penny stocks, make sure that you are able to differentiate between genuine volume and fake volume. This is because many penny stock companies tend to pile up the trading activity of a stock through insider traders who buy and sell the stock for the sole purpose of boosting the stock price.
Therefore before you jump on to investing in penny stocks, make sure that the promising trading activities you see on various charts reflect the real picture which includes genuine retail investors buying the stock and not insiders trying to pump and dump the stock for capital gains.
Beware of the lack of minimum requirements for some of these stocks
Most penny stocks are traded on the pink sheets or the OTC market which have no minimum requirement for listed companies. The NASDAQ and the NYSE have minimum requirements of a stock price of at least $1.00 alongside other volume and market cap limits.
Now since most of these stocks trade under very accommodative rules and regulations for listed companies, the circumstances may not be as conducive for investors. This is because a penny stock can be worth $1.00 today, only to fall to $0.10 cents the following day without causing alarm. As such, investors should be careful before investing in penny stocks.
Beware of stock promoters and mailers
Stock promotion is a common theme in the OTC markets and actually, some investors go on looking for penny stocks that are being promoted in order to invest. As such, when you happen to sign up for a newsletter in one of the penny stock websites, beware of what comes in your inbox before choosing to invest in the promoted penny stocks.
Most of them will begin by highlighting how much you could gain in a couple of days or weeks, usually in hundreds of percentages, but try to avoid making your decision based on that nevertheless. This is because the sender of that email may have probably been paid by the company in question to promote the stock by targeting those interested in investing in penny stocks.
In summary, investing in penny stocks carries a higher risk than when investing in normal stocks (stocks with good genuine trading volumes, reasonable market capitalizations, and decent price per share). As such, when investing in penny stocks it is good to be on the lookout for the many traps to avoid falling into one.