In this article, we’re going to go over some basics. We’ll discuss the definition of penny stocks, the pros & cons, plus some extra details you should know before jumping into the market.What Are Penny Stocks?
A penny stock represents the stock of a company that trades for less than $5 per share. Many penny stocks are available to buy, and you can find them trading on major exchanges like the NYSE and Nasdaq. You can also buy penny stocks trading “over-the-counter” or “on the OTC,” a lower-tier exchange.
Since penny stocks trade at very low prices, the companies they represent are usually smaller in size. However, this isn’t always the case. If you look at Ambev (NYSE: ABEV) or Southwestern Energy (NYSE: SWN), for instance, the companies themselves are not that small. In fact, both hold market capitalizations of more than $3 billion.
The main attractions to penny stocks include a few things:
- You can buy many shares with smaller sums of cash.
- There’s an opportunity to invest in early-stage companies.
- Penny stocks allow traders & investors to leverage capital in exchange for the opportunity of exponential gains in the market.
But let’s also not forget with all investment vehicles, risk plays a large role too. Just as quickly as penny stocks go up, they can also come back down.Penny Stocks & Volatility
The term volatility refers to the rapid fluctuations in the share price of stocks. When it comes to penny stocks, volatility is evident. If you’ve got a $1 stock that goes up just 10 cents, that equates to a move of 10%. Aside from monetary gains, that 10% move is substantial. If a stock like Apple (NASDAQ: AAPL) were to jump 10%, it would need to rise over $10 a share.
But penny stocks usually shift more than 10% in a given day. This year, there’ve been times where stocks under $5 have rallied several thousand percentage points between opening and closing bells. On a longer-term time-frame, some penny stocks have climbed tens of thousands of percentage points over the course of a few weeks or months. Take, for instance, GameStop (NYSE: GME), the talk of the stock market in 2021. In April of 2020, GME stock had traded as low as $2.57, well-into penny stock territory. Less than 1-year later, the penny stock had climbed to highs of $483, equating to a move of 18,693.77%.
But penny stocks don’t always need to go to highs of over $100 to see significant gains. Zomedica Corp. (NYSE: ZOM), an animal diagnostics technology company, saw its shares trading under 10 cents in November of 2020. A few months later, ZOM stock reached a high of $2.91 in advance of its first commercial product sale. Though the move was less than $3, it equated to 4,750%.Advantages Of Penny Stocks
One of the biggest advantages of finding the best penny stocks to buy is the ability to turn a small investment into big money. The examples I gave above are just a few of the many big moves that penny stocks have made over the years. Now, all stocks under $5 don’t make such dramatic jumps. However, even on the lower end, traders can see 1-day moves of 30% or more on the lower end.
Considering that the market, as a whole, fluctuates a few percent each day & 10-12% on average per year, there’s an argument that can easily be made in favor of choosing penny stocks to buy above mainstream, blue-chip stocks. This creates a lot of excitement among investors and traders alike.
Another one of the advantages of penny stocks is investing in a public company at an early stage. I’ll be the first to say that smaller companies fail and can go to zero. But there have been many instances where penny stock companies have turned into market-leading conglomerates. This has presented a massive opportunity for investors who took positions at levels under $5.
Take, for instance, Novavax Inc. (NASDAQ: NVAX). It had been working on treatments for influenza. However, the 2020 pandemic created the early opportunity to eventually see the company become a competitor of Pfizer (NYSE: PFE), Moderna (NASDAQ: MRNA), Johnson & Johnson (NYSE: JNJ), and others. Novavax focused on creating a COVID-19 vaccine candidate along with hundreds of other biotech companies. However, those investors who saw the company’s platform and did their research would have seen the now $150+ stock trading below $5 when it just began its R&D. The stock even traded as high as $331.Disadvantages Of Penny Stocks
You can’t have risk/reward without the risk. Are penny stocks high risk? Yes, when you’re talking about stocks under $5, the risks are high. Volatility can play an important and detrimental role when traders work against you. Just as quickly as the price can rise, it can fall, leading to big losses in the market.
The lower share price creates the impression that small moves can create big windfalls. But many traders take this idea and invest even larger sums of money with the “hope” of making even more. Never risk more than you can afford to lose because if that trade turns against you, it could mean a huge monetary loss.
Also, liquidity can be a major disadvantage in many cases. Let’s say you found a company that is developing a novel cancer treatment. The research is positive, management is sound, the last Phase Trial update showed promise, and now you want to invest. Since penny stocks are not as actively traded as higher-priced stocks, liquidity can be a risk in itself. This refers to how active a stock is traded.Liquidity Risk
If you want to invest $1,000 into that biotech company but it only trades $200-$300 a day, it may not be worth it because your investment would be much more than the stock’s average trading volume. The risk comes when it’s time to take profits. If there isn’t enough liquidity to sell your shares, you’re at the mercy of the market, which can mean not getting optimal pricing or not enough buyers to sell to.Penny Stocks & Reporting Requirements
Another disadvantage is with OTC penny stocks. Since the OTC doesn’t require as much transparency in filings as the NYSE or Nasdaq, some companies don’t give the full picture. This makes it very hard to put together a sound strategy based on fundamentals. When you’re talking about investing in penny stocks vs. trading them, fundamentals play a bigger role than market momentum. If information isn’t publicly available, you can find it hard to gain the right insight to base your investment on.The “Robinhood Risk”
This is something that not many people discuss, but it could pose a big risk to those looking for penny stocks to buy. Thanks to the surge in new retail traders, apps like Robinhood & Webull have grown in popularity. These platforms make it easy to trade penny stocks right from your phone. But there’s an underlying risk, especially when factoring in stocks under $5.
Both Robinhood & Webull, for the most part, only allow access to NYSE and Nasdaq-listed stocks. These exchanges require the companies listing on them to meet certain, basic things like trading above $1 and audited financials. If you’re looking for penny stocks on Robinhood that are under $1, the risk is that the companies won’t regain proper price levels and, in turn, get delisted from the major exchanges.
Even if you’re up on your investment, you run the risk of not having access to trading in your position. At the very least, Robinhood or Webull may only allow “closing transactions,” IE you can only sell shares.Should You Buy Penny Stocks In 2021?
If you’re asking, “Are penny stocks worth it?”, there are plenty of reasons why penny stocks present great opportunities for traders and investors alike. Since we’re talking about stocks under $5 per share, the ability to pick up a sizeable position for not a lot of money gives smaller traders leverage they wouldn’t otherwise have if they bought blue-chip stocks like Tesla (NASDAQ: TSLA) or Amazon (NASDAQ: AMZN). The increased volatility also offers the ability to secure gains quickly, not having to wait months or years but days or hours in some cases.
This doesn’t come without plenty of risks, however. Volatility can work against you with quick drops instead of big jumps. As a result, while 20-50% moves higher are great, a similar move in the opposite direction can be a crushing blow to your portfolio. Should you buy penny stocks right now? That will depend heavily on your personal risk tolerance and understanding of how to trade these types of stocks in the first place. If you’re just getting started, here are a few articles that may help get you some good information on trading penny stocks: