Risks involved in penny stocks.

Risks of Penny Stock Trading

The investing adage "buy low, sell high" is good advice. There's nuance to it, however. "Buy low" doesn't mean "buy the cheapest stock possible". Similarly "sell high" doesn't mean "wait for it to become the most expensive stock possible". In this context, low and high are relative terms which refer to the underlying value of the business itself: buy when it's undervalued and sell when it's overvalued.

Novice investors commonly look for extremely cheap stocks, figuring that a stock selling for Rs 1 has a lot more room to double or quadruple in value than a stick which sells for Rs 10. Novices commonly fall into the trap of looking for penny stocks to buy. This is risky, but you can avoid this.

What is a penny stock? It's a stock that generally sells for less than five dollars per share and trades outside of a major exchange. These stocks are cheap for a reason: they usually belong to companies in bankruptcy or other financial troubles. These stocks are popular in certain circles, but they're very risky. You might also hear them referred to as microcap stocks or pink sheet stocks. It's all the same thing.

Why Do People Get Started Trading Penny Stocks?

A cheap stock may seem on the surface to give you good value for your money. If you ten thousand rupees, you can buy 20 shares of Tata Motors at Rs 500 and 20000 shares of some random stock selling for Rs 0.50. Which would you rather have twenty shares or twenty thousand? Psychologically speaking, it seems like it's easier for something selling for Rs 0.50 to go up to a Rs 1 (doubling your money) than it is for Tata Motors to go up to Rs 1000 (doubling your money).

The problem is that the value of a stock depends on two things. First, its value is whatever someone's willing to pay for it. With millions of shares changing hands every day, millions of people are judging what stocks are worth. Two, the value of a stock depends on the value of the business behind it. It's much better to own a company that's making money than it is a company that's losing money. People are willing to pay a little more for the privilege of owning part of a successful business than they are to own part of a failing business.

Most of the time, a stock price below a dollar means that people think the business is in trouble. Most of the time, they're right. Even if you've found likely candidates, penny stock trading is one of the riskiest types of investing.

Struggling Companies and Buyouts

It gets merged with another company. Sometimes that happens, or sometimes a stock gets bought out entirely. In that case, the acquiring company will often make a bid for the troubled company, based on what they think the company is really worth. That's probably the value of the assets: real estate, inventory, existing contracts minus existing liabilities.

In the case of an acquisition, the acquiring company may either pay existing stockholders a fixed price per share or convert shares of the acquired stock into shares of the new parent company at some ratio.

Sometimes this is a good deal. Sometimes it's a fair deal. Any profit you make depends on the price you paid. If it's below the acquisition price, you might make a little profit. In this situation, timing is everything. You have to buy the stock for less than what it will sell for.

How do you know what it'll sell for? You have to figure out what the company as a whole is worth—its inventory, any existing contracts, any investments, the value of real estate, and the opportunity costs of acquisition. That's a lot of financial analysis for a company that'll probably go bankrupt.

Selling Penny Stocks is a Difficult Task

Of course, to buy a stock at the right price, you have to find someone to sell it to you at that price. That's not easy. Unlike a normal stock, where people buy and sell based on actual value of what the company can actually make, penny stock trading relies on speculation. Everyone who owns the stock is waiting for it to turn around somehow. Maybe you'll get lucky and someone who bought it for Rs 0.20 a share is willing to unload a few thousand shares at Rs 0.50 a share, but it's more likely that anyone who bought it wants to make 10 or 20 or 50 times profits.

The same goes for getting out of a stock. Sure, you bought it at Rs 0.25 a share and good news has raised it to Rs 0.50 a share, and you think you're as lucky as you're ever going to get, but are there enough buyers at Rs 0.50 a share for you to sell all of your shares?

Penny stocks have very little liquidity. There aren't many buyers and sellers because they're so risky. Unlike a share of Reliance stock you can buy or sell pretty much anytime near the asking price, there aren't enough buyers and sellers who agree on prices, so their prices have wild swings. You're going to have to have great timing and even better luck to sell at the price you had in mind. That's after you've gone through all of the hoops in How to Buy Penny Stocks.

Sure, you can wait for the company to turn around—but most don't. Most don't get acquired. Most go out of business.

If you're looking to get rich while day trading penny stocks that lack liquidity, will work against you. If you're at all ethical—if you're not defrauding other people with pump and dump scams—you're relying on luck, and luck is a poor investment strategy. As well, patience works against you. You have to race around the clock before these poor companies go out of business altogether. That "hot penny stock tip" you just saw in email? That's someone's desperation trying to trick you into buying what he really wants to sell.

People often ask where to buy penny stocks. You can generally buy them through any reputable stock broker, though you'll likely have to sign a disclaimer that you understand the risk of smallcap trading. In shadier corners of the Internet, you can find businesses which purport to specialize in these trades, but trust may be an issue. Any reputable stock broker will have to run you through several pieces of paperwork to ensure that you understand the risks of this type of investing.