While penny stocks can turn small investments into a fortune, they are volatile in nature. Investing in them calls for care and caution

It is the dream of every investor, in fact, every human being to become rich overnight. But sudden riches can only come through speculation. One of the many ways of generating higher returns with lower initial investment is by investing in penny stocks. These are common shares of small public companies or public firms turned private that trade at low prices per share. A penny stock refers to a small company’s stock that typically trades for less than $5 per share. In India, they are defined as those stocks which trade at a very low price ie Rs 10 or Rs 5 or less.

Although these stocks have very low entry costs, they are potentially very risky. To begin with, penny stocks have very low market capitalisation, trading volume, liquidity and in most cases, lack liquidity completely. In case a stock is less liquid, holders of shares in penny stock companies often find it difficult to cash out of positions. Also, the cost of trading these stocks is very high. Another potential risk is the bankruptcy of a penny stock company. On bankruptcy, its shares are eventually cancelled and become worthless. Any remaining assets are sold to pay back the banks and creditors. But after the bankruptcy announcement, stocks may continue to trade on the stock market for weeks or months and traders can still buy/sell the shares, which can cause problems for uninformed investors.

More importantly, the information available to investors, in case of penny stocks, is less reliable and not readily available and without enough information. An investor may not be able to fully evaluate the company. Less stringent disclosure requirements can make penny stocks particularly susceptible to illegal schemes. Because they are often small in size, penny stock companies do not receive the same level of media and analyst coverage as larger public companies and so it can be difficult for investors to determine the validity of claims made by speculators. Unfortunately, those who bought the stock at the high-end, could be left high and dry.

So, there are definite risks associated with penny stocks and an investor may even lose all the money because of the volatile nature of the shares. Penny stocks are simply the low-priced speculative securities of small companies. The greatest advantage with these stocks is that they can turn small investments into a fortune. The greatest risk associated with these stocks is their volatile nature. However, one may certainly minimise the risks by following a proper strategy.

First, remember that penny stocks are low-priced shares, not free. If someone offers to sell these socks free of cost, be alert. Two of the sources of such free offers may include an unsolicited email or a free newsletter. In most cases, these are just propaganda. Second, invest only in penny stocks that are listed on premier exchanges. Third, the higher the volume of these stocks, the safer your investment is. If the volume is less than 20,000 shares traded per day, one should understand that there is something wrong with the stock. Fourth, research, research, research…..One of the best ways to avoid risks is to do your own research. Get a feel of the company and analyse how it makes its money. Make sure that the company has a strong business plan and a good profit history. Keep an eye on the trends of improvement. In case research is not possible, it is important to use the service of professional stock-picking company or a website. While researching the penny stock, a review of its current debt liabilities — both short and long-term — and comparing the total debt with total assets is imperative. If the debt of a penny stock is high with low market cap, it can be deduced that the firm is distressed and will unlikely obtain future financing on acceptable terms. Also, historic share price levels over at least a three-year period have to be analysed. And finally, never put all your money into one stock.

Of course, there is the potential to make money investing in penny stocks. For some, such stocks seem to have several attractive features: The ability to buy a relatively large number of shares due to low stock price and the potential for quick gains. Some penny stock traders may trade tens of thousands of shares for a relatively low amount of money, hoping that the price will rise sharply over a short period of time. In exchange for being able to buy a large number of shares — due to a penny stock being relatively low priced — investors in these companies are taking on a dramatic increase in potential price volatility and risk; there is an even stronger chance that investing in penny stocks could result in losing part or all of your investment. The bottom line is this: Trading penny stocks can be extremely risky and is only suitable for risk tolerant investors. Retail investors, who are risk-averse, should stay away from penny stocks.

(The writer is Assistant Professor at Amity University)