What are Penny Stocks? Pros and Cons of Penny Stocks

What are Penny Stocks?

In India, penny stocks are defined as scrips trading below ₹10. They are known to have low liquidity and high volatility. They can give investors high profits, but their stock price movements tend to be difficult to predict. Therefore, penny stock investments are often considered speculative.

Penny stocks are frequently used in fraudulent activities, like pump and dump schemes, where the stock prices are manipulated.

The Pros of Investing in Penny Stocks

Low cost

Penny stocks trade for a very low price. Suppose the lot size of a penny stock is not so big that an investor needs to put forward a similar amount of capital as they would with blue-chip stocks for a meaningful quantity. In that case, newcomers to investing will find penny stocks approachable as compared to investing in blue-chip stocks, which have larger per-share prices and huge volumes. So, you may invest in penny stocks without needing huge capital and yet attain a bigger volume.

High Returns

New and small companies who haven’t made it big yet, may often start as penny stocks. Investing in such companies before they make it big and thereby reaping the returns makes penny stocks attractive. Good penny stock in Indian markets may allow an investor to make humongous profits.

Chances of overnight gains

Penny stocks are issued by small companies that haven’t yet reached their potential. Suppose a case where a penny stock company suddenly enters the headlines for the right reasons (for example, good credit ratings, sound fundamentals, good management, good market positioning, etc.). In that case, they might experience overnight gains in stock prices.

Discover stocks that suit certain filter criteria and dive into details to check their WealthBaskets.

The Cons of Investing in Penny Stocks

Unpredictable pricing

Predicting the price of a penny stock is very difficult due to limited information, infrequent trading and the scope of fraudulent activities. The price ceilings and floors are more flimsy in penny stocks than blue-chip stocks. An investor may make a lot of money overnight. On the flip side, they may also lose it in even less time. Even the top penny stocks with high market capitalization may experience extreme volatility.

Limited information

It is challenging to learn about a penny stock company’s financial soundness, management quality and overall performance. As compared to blue-chip companies, an investor will have a lot less research on their hand while making trading decisions in penny stocks. Often there is hardly any information about their historical performance as a business.

Low liquidity

Even if you have never invested in your life, you can name at least one large-cap company just by looking around your room for some branded products that you may own. On the other hand, penny stocks do not enjoy this popularity. This is reflected in their low trading volumes. Low trading volumes make it difficult for investors to buy or sell penny stocks. An investor may feel locked in penny stocks as there might not always be a person willing to take the other side of the trade.

Prone to scams

Due to the low trading volumes and stock prices, penny stocks are attractive to scammers aiming to manipulate the price to make profits at the expense of unsuspecting investors. Investors may lose significant amounts of money due to some parties or groups manipulating the price.

Pros and Cons Of Investing In Penny Stocks

Investing in Penny Stocks

Investing in penny stocks may often be like holding a lottery ticket. No sane person buys lottery tickets with all their savings. Investors should limit the portion of their portfolio they assign to penny stocks. Since the risk is high and liquidity is low, invest only an amount per your risk appetite. Due to the low trading volumes, there’s no guarantee that you will be able to pull out money in time to reap the benefits.

People often talk about Ford Motor as a stock that surprisingly turned into a penny stock. In 2009, Ford Motor was trading close to $2 per share and bounced back to $10s by the end of the year. You should note that, in 2009, Ford was a 106-year-old company that turned into a fundamentally strong penny stock. All penny stocks may not have the same features.

You may be able to find Indian penny stocks with good fundamentals. Debt-free penny stocks with strong fundamentals may seem like potential multi-bagger penny stocks. But you should also keep an eye on the trading volumes. Investors should be careful and go the extra mile in their research on penny stocks. Along with fundamental research, investors must do technical analysis as well, if possible, to gauge the right entry and exit point.

Check out our guide to technical analysis of stocks.

Conclusion

It is rare for penny stocks to make it big. Low trading volumes make it difficult to trade in penny stocks. As a result, investors may find themselves locked in loss-making companies. The lack of information is also a deterrent to such investments. Therefore, investors must check the fundamentals of a penny stock and do their research before investing in penny stocks.

On WealthDesk, you can invest in portfolios of stocks and ETFs geared towards various financial goals like high growth or stability and themes like banking. These portfolios, called WealthBaskets, are curated by SEBI-registered professionals. As opposed to mutual funds, the assets in WealthBaskets are transferred directly into the subscriber’s account. This gives investors more control over their portfolios.

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