Ever see the movie “Wall Street”? Or how about any market related move out there? The rush of trading runs through everyone’s veins but most novice traders don’t have access to capital to trade “with the big boys,” so they choose to try their hands at trading penny stocks. These stocks are low priced equities that typically trade below $1. The actual definition of a penny stock states that they trade below $5 but hey, we’re talking pennies here.
The big glaring outlier with penny stocks, however, is the companies that are connected are typically early stage or development stage companies. Many of these penny stock companies can be risky investments and a lot of these companies lack the strong fundamentals that other “Blue Chip” companies have…like revenues, earnings, or even well put together financial statements. Just know that there are many risks involved with trading penny stocks and you need to be able to stomach these risks in order to reap the rewards.
Can You Stomach Volatility From Penny Stocks?
Penny Stocks can bee very volatile. We’re talking huge swings in the market that can be as big as thousands of percentage points in a single day. Generally speaking, because many penny stocks to trade are thinly traded, it doesn’t take long for them to increase in price. It also should stand to reason that it may be a lot sooner for something to jump a few pennies in comparison to a few dollars and equate that to a larger percentage gain. Look at a company like Apple (AAPL). If that stock were to move up a few pennies, that really wouldn’t equate to larger percentage gains but if you take a penny stock that is trading around 5 cents, then a few pennies could mean 20% or more in a single day. For a stock trading at $100, it would need to move up 2,000 pennies in order to hit 20%…put that into perspective.
3rd Party Funding
But then again there are many external factors that can impact a penny stock negatively. Most focused on lately have been funding sources for many of the penny stock companies that we see every day. Without getting to drawn out: because these companies can lack access to capital because they have no assets or very little to start, they need to go to funding sources that take on risky investments. Many times these funds will invest tens, hundreds, thousands, or even millions of dollars in exchange for convertible debentures or notes. Essentially, it’s like a loan except the collateral for the loan is shares of the company.
If the companies do not pay back their loans within the allotted time, the lender (in this case the fund) can elect to convert the debt into shares of the company. Most of the time the conversion price is a fraction of the current market price and therefore will give these funds a lower cost basis than normal retail traders who buy at market prices.
Where’s the risk? Well if a funding party immediately converts their debt into shares, they can sell them at the discounted cost basis to make a profit and since their cost basis is far less than the market, they can afford to sell the shares much lower than anyone who purchased shares in the open market. This could greatly pull down a stock price, cause panic selling, and an entire penny stock investment could become worthless. So it’s very important to know risks like this when it comes to finding penny stocks to trade. Do your diligence, look at the company’s financials, and investigate management as well as funding sources to determine what potential risks can be involved.
Risk Versus Reward
Obviously this is completely a non professional, unlicensed take on penny stocks. If you have questions regarding actual trades, don’t take our word for it at all and do not take this as advice on do’s and don’ts; consult a licensed financial representative. This having been said, risk and reward are key here because with great risk could come great reward. Many times it will come down to timing. Even the thinnest traded penny stock could breakout big and everyone wants to be there when it does.
Knowing how to capitalize on market momentum and knowing what catalysts could be at play become a key role. Is it a news catalyst, is the industry as a whole increasing, are there promotions going on? All of these kinds of questions have answers and knowing what roles they play during any particular breakout could determine someone knowing when to buy a penny stock and when to sell a penny stock.
In the end you need to ask yourself one question after seeing the risks and rewards, “Are penny stocks really for me?”