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Buying Penny Stocks and its Risks

ICICI Securities 05 Sep 2021 0 COMMENT

There is a specific category of stocks whose prices are very low and they seem to yield exponential returns. But do you know that investment in such stocks could be risky? Such stocks are known as penny stocks and in this article, we will understand what penny stocks are and the risks involved in trading them.

Firstly, let’s understand what are penny stocks.

The defining characteristic of penny stocks is that they trade at very low prices. In India, they are typically priced lower than Rs.10. These are the stocks of companies with relatively low market-capitalization and therefore, such stocks can also be called nano-cap or micro-cap stocks.

These stocks may have explosive moves and yield high profits in a relatively short span of time, ranging from a few weeks to even days.

Penny stocks happen to be rather attractive to some investors as they think they can buy large quantities of such stocks for a relatively lower price and then hope to get exponential returns if the stocks were to turn into a multibagger.  Investors expect these companies to grow faster or think that they are on the verge of turnaround and their share price can multiply from here.

The important thing here is that many a times the risks posed by penny stocks far outweigh the possibility of such stocks yielding exponential returns.

Let’s now go through the various kinds of risks involved when it comes to investing in penny stocks:

Firstly, penny stocks have very low liquidity. Such stocks lack trading volume and are associated with problems on both the buying and selling ends of the transaction. In many cases, investors looking to buy penny stocks cannot find a corresponding seller and in the worst-case scenario where you bought the stock and its price starts tumbling down rapidly, you cannot find a buyer to sell the stock to. This lack of liquidity may end up wiping out the entire principal amount invested in the penny stock.

And due to lower trading volumes and lack of liquidity, penny stocks are characterised by a large bid-ask spread, which is the difference between the highest price a buyer is willing to pay for the stock and the lowest price that a seller is willing to accept.

Secondly, there is usually a lack of information about penny stocks companies. As we discussed, these companies are not well known and, it is generally challenging to find information regarding future growth prospects, past track records of performance, operational stability, financial soundness, ability to generate profits and a lot of other factors. Investors need to consider and find relevant information before investing their money in such companies.

Thirdly, penny stocks are prone to price manipulations. One can easily inflate their prices by buying large quantities of these stocks or heavily deflate the prices by short-selling them. There have been past-instances of entities with ulterior motives resorting to such manipulative practices so that they can profit at the expense of common investors who bought the stocks with hopes of earning a profit. Many of these companies could be loss making and some may have corporate governance issues.

And due to penny stocks being prone to price manipulation, they are ripe grounds for scams. 

One of the most common methods is the pump-and-dump, where promoters and influencers try to attract attention towards a lesser-known company by lifting the share price. After reaching certain levels, these promoters, influencers or insiders then liquidate their entire positions thereby earning a profit at the expense of these investors, who end up with bad losses and also potentially lose their entire capital which they invested.

Other than these risks, companies which issue penny stocks may suddenly decide to delist from the stock exchange or be put under scrutiny by regulatory authorities. 

Generally speaking, due to the lack of information and other factors we discussed, it is tough to spot penny stocks with sound fundamentals that can generate high returns. Such penny stocks are significantly less in number than the stocks whose issuing companies may become bankrupt and ultimately go out of business.

On an ending note, penny stocks are an extremely risky bet. One should do all the due diligence before making the decision to invest in penny stocks.

Let’s finally summarize everything we discussed:

  1. Penny stocks trade at very low prices and these companies have low market capitalization.
  2. They tend to attract investors due to their low price, but are very susceptible to market volatility and happen to be incredibly risky.
  3. Penny stocks have low liquidity and lack trading volume, due to which investors can find it to be particularly difficult if they wish to buy or sell their positions.
  4. Penny stocks are prone to price manipulations.

Disclaimer:

ICICI Securities Ltd. ( I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Centre, H. T. Parekh Marg, Churchgate, Mumbai - 400020, India, Tel No : 022 - 2288 2460, 022 - 2288 2470. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investments in securities market are subject to market risks, read all the related documents carefully before investing. The contents herein mentioned are solely for informational and educational purpose.