Mitigating Risks Involved with Penny Stocks

There is a popular saying that good things don’t come easy. People who trade in the stock market know this very well. To profit substantially by trading stocks, one must educate oneself, research, and be patient. However, penny stocks change this scenario because they promise huge profits quickly. 

Penny stocks, also known as micro-cap stocks, are shares of small companies that trade at a low price, typically under $5. Investing in these stocks can be very tempting for speculative investors who want higher returns for low investments. And the best part is you will find numerous promising penny stocks poised for growth.  

However, one must be careful while investing because of the risks involved.

What is Penny Stock?

Penny stocks are shares of those companies that have small market capitalization. The price of these stocks is between $1 to $5. These stocks are considered high-risk stocks because they have high volatility, low liquidity, and are prone to fraud.

These stocks are primarily not listed on the New York Stock Exchange and can be traded through an over-the-counter transaction or on the electronic OTC Bulletin Board (OTCBB) system.

Risks Associated with Penny Stocks

If you have seen the movie “ The Wolf of the Wall Street,” you are probably aware of how fraudulent parties manipulate stock prices for their own benefit. Among all the types of stock, penny stock prices are more easy to manipulate, giving way to more risks and frauds. 

The risks associated with investing in penny stocks are:

Frauds and Scams: Fraudsters pressure naive traders to buy penny stocks. They are fooled into buying these stocks and then misinformed about the price inflation. This is called the “pump art.” Once the prices rise, they utilize the “dump art,” where the sellers sell these stocks. This crash leaves naive buyers with penny stocks that are worth nothing.

These frauds can happen with any stock. However, penny stocks are more prone to such manipulations because they are not traded on the traditional stock markets.

Highly Volatile: Even if every penny stock is not a scam, all of them are highly volatile. With these stocks, a slight rise in the stock price can lead to a high percentage of gain. But at the same time, not many investors can handle the losses when things go wrong.

Low Trading Volume: Penny stocks don’t have a lot of buyers. With mainstream stock, even if there is no single buyer, the brokerage firm will take your stock because they know they will find buyers later. But this is not the case with penny stocks. Firstly, they are not listed on the major stock exchanges. And even if they are, they don’t attract buyers because of the associated risks. 

Therefore, they don’t provide buyers with liquidity,

The companies are not trustworthy: The penny stock companies are not trustworthy, and most of them don’t even have a proven track record. With mainstream stocks, investors can research the companies adequately. There is a lot of information about them online. However, companies with penny stocks don’t have much information, making it hard for investors to speculate.  

Mitigating the Risks Associated with Penny Stocks

The prices of penny stocks fluctuate throughout the day depending on the market. Traders rely on these short-term fluctuations in the prices of penny stocks to drive profit. Penny stocks are highly volatile, and a piece of positive news in the market can lead to an increase in the price. 

But at the same time, a piece of negative news running around can lead to a significant price crash. The risks involved with penny stocks are high. But they can be mitigated to some extent if you keep in mind the following points/

1. Develop a Risk-Aware Strategy: Penny stocks are inherently risky. They are highly volatile, have limited liquidity, and have a higher chance of fraudulents. When buying these stocks, you must know these risks and invest what you can afford to lose. You don’t know what the future holds for a particular stock. Therefore, it is best to be aware of the risks and have your expectations to zero.

2. Diversify Your Portfolio: Penny stocks should never make up most of your investment portfolio. You are welcoming a heavy risk and loss if you do this. They are best suited as a small part of a diversified investment strategy.

3. Risk Management: Establish a clear risk management strategy before buying penny stocks. You can have a stop-loss order to limit the potential losses. With penny stocks, you must be highly disciplined and set strict risk parameters to mitigate the losses.

Conclusion

Investing in penny stocks is an excellent option if you want to invest a small amount of money but desire greater profits. Even though penny stocks are very risky, you must know that many big companies, such as Amazon, started with penny stocks, and look where it is now!

However, this may not be the case with every company. Therefore, be aware of the risk involved when investing in penny stocks, plan out a risk management plan, and invest only what you can afford to lose.