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What are penny stocks and should I invest in them?

Penny Stocks

If you’re interested in growing your wealth through investing, you may have done some research to find out some common strategies. You may have heard about penny stocks but it isn’t immediately clear what they are.

To put it simply, this involves buying and selling stock in cheap companies. Everyone loves a bargain, but this can sometimes be deceptive.

Trading penny stocks can be a valid investing strategy but it can come with significant risk. That’s why if you’re considering it, it’s important to be able to make an informed decision.

Read on to find out everything you need to know about penny stocks and whether you should invest in them.

Where to buy penny shares

Find the best trading platforms to buy penny shares.

What are penny stocks?

To put it simply, a penny stock is a riskier investment that involves buying shares of companies that are going cheap.

Typically, in the UK it is for companies trading at less than £1 a share (hence the name) but in other countries, this limit may be higher. For example, in the USA, company shares trading for less than $5 are considered penny stocks.

The cheapest available shares of this type are sometimes known as “sub-penny stocks” and typically trade at less than one pence per share.

While some penny stocks trade on major stock exchanges, such as the New York Stock Exchange or London Stock Exchange, they are more often traded through “over-the-counter” transactions.

What are “over the counter” transactions?

An over-the-counter (OTC) market is the place where you go to trade penny stocks.

This is typically an online trading service managed by a supervising body, such as the Financial Industry Regulatory Authority in the US. Transactions are also often regulated by a governmental body, such as the Securities and Exchange Commission.

The benefit of this supervision is that companies have to meet minimum standards of financial responsibility, such as providing up-to-date financial statements.

Penny stocks are also sometimes listed on publications like the pink sheets, but they don’t have these same rigorous requirements. This means you have less information to base your decisions on, meaning you may be exposed to greater risk.

What is an example of a penny stock?

Penny stocks can be shares of any company which are worth around or less than £1. For example, British manufacturer Rolls-Royce is now considered a penny stock.

During the pandemic, there was a significant decrease in their share price, as the reduction in air travel meant that there was less demand for their services.

However, since this fall may be reversed as international lockdown restrictions end and life returns to normal, there is the prospect for the value of this penny stock to rise in value. If it does, you could make a large profit.

What is the difference between penny stocks and small-cap stocks?

Penny stocks are often confused with small-cap stocks and it’s easy to understand why as, on the face of it, they seem very similar.

However, the main difference between the two is in how they are valued. As it says on the tin, penny stocks are defined by the trading price of their stock, while small-cap stocks are defined by the total value of their market capitalisation, or “market cap”.

Typically, small-cap stocks are ones with a market cap of under $2 billion. They are often young businesses or ones that operate in new or niche markets, such as technology.

Like penny stocks, they often have the potential for fast growth, but buying them can also leave you open to the risk of losing money rapidly.

What are the benefits of investing in penny stocks?

There are two main attractions for investing in penny stocks. The first is that if you only have a set amount (for example, £1,000) to invest, you can buy a much larger share percentage in a smaller company whose shares are only trading for a small amount.

Buying a similar percentage of ownership in larger and more well-established companies, known as “blue chips”, may cost you considerably more. And of course, there is always the hope that, with a bit of luck, your penny stock price rises, and the company might one day go on to join the blue chips.

If this happens, you could see a large return, which brings us to the second attraction – while they are high risk, they have the possibility for significant growth. This means that you can turn a small investment into a large amount of wealth very quickly.

Can you make money with penny stocks?

It is very possible to make money with penny stocks, although this is also true for investing in many types of stocks.

There are many good reasons to invest in small companies, as mentioned above, but most penny stocks are rarely the bargains that they appear to be on the surface. If something seems too good to be true, that’s because it usually is.

Penny shares are often cheaply priced for a good reason. Typically, penny stock companies are unproven at best, with some investors considering them to be little better than speculative stocks.

This is why if you plan to make money trading stocks, it’s important to do your research before investing.

What are the risks of penny stocks?

An easy mistake to make for penny stock investors is to think that a low share price means that the company has a better potential to grow than one with a higher share price. While this is sometimes true, it often doesn’t represent the whole picture.

In reality, the value of a company (also known as its market capitalisation) is affected by two factors:

The stock price

The first factor is indeed the stock price, but this can paint a misleading picture of a company’s value. Another important factor to consider is the number of shares that the company has issued.

The number of shares

This factor is crucial to working out a company’s true value, as the number of shares that they have issued is entirely up to them.

For example, a company with 1 million shares outstanding, at £100 per share, is worth as much as a company with 100 million shares at £1 per share. Furthermore, the company with a £100 share price may have greater growth potential than the one with a £1 share price.

Since regulators are aware that penny stocks are highly tempting, and that the share price can be misleading, the major market exchanges where you can buy them are often explicit about the risks they present.

Are penny stocks good for beginners?

If you’re only just getting started with investing, you might be tempted to start with penny stocks. There are both positives and negatives to this option.

On one hand, if you don’t invest too much and leave yourself open to the risk of a large loss, they can be a useful way of gaining experience with stock trading.

However, one major risk is that there is a considerable amount of risk when buying penny stocks. If a chosen stock plummets further in value, you could put yourself at the risk of losing money rapidly. That’s why it is important to do your research before you start.

How can I choose which penny stocks to invest in?

If you want to make money with the penny stock market, it is important to be able to make an informed decision. Since some of the more risky penny stocks are essentially highly speculative investments, if you don’t know the market, you may be exposing your wealth to significant risk.

A good start is to monitor the news for big events which could affect the stock markets. This can help you to have an idea of how you could benefit.

Alternatively, you may benefit from seeking professional advice. An advisor can help to act as a sounding board for your financial decisions, helping you to find the best penny stocks to increase your chances of seeing returns on your investments.

Summary: what are the pros and cons of buying penny stocks?

When it comes to penny stocks trading, there can be a lot of things to bear in mind. If all this seems too much to remember, here are the essentials that you need to know:

Pros of buying penny stocks

  • If you invest in the right companies, you could see significant returns on your initial investment.
  • Since penny stock companies tend to be smaller, you can buy a larger share percentage than you could for a larger company with the same amount of money.
  • It can give you valuable experience in how trading works.

Cons of buying penny stocks

  • Many penny stocks come with a significant amount of risk attached.
  • It can sometimes be hard to predict price fluctuations when it comes to penny stocks.
  • Share prices can be deceptive, so make sure to research other factors like the number of shares that a company has issued.

How you can get started

  • Make sure to do your research before you start to improve your chances of seeing a return.
  • Find a trading platform to invest in or speak to a stockbroker.
  • Spread your risk into several stocks to reduce the risk of losing your entire investment.
  • Accept that liquidity may be lower than on the main market as there are fewer buyers and sellers for penny stocks.
  • Seek professional financial advice to maximise your chances of seeing a return.

How can working with an advisor help me?

If you want to buy and sell penny stocks, it’s important to be able to make properly informed decisions. If you don’t you may be exposing yourself to unnecessary risk. This is why it’s important to seek professional advice before you invest.

Working with a financial advisor can help you to make an informed decision when investing in penny stocks to help you weigh up the pros and cons of an investment.

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They can also help to explain financial concepts, such as how spread bets and CFD trades work so that you can invest with a greater degree of confidence. This can help you to grow your wealth more effectively, as it can give you better options and avenues for investment.

It can be easy for retail investor accounts to lose money when trading penny stocks, so if you want to reduce the chance of that happening to you, it’s important to seek professional advice.

Please note:

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

This article is for informational purposes only and does not constitute financial advice. All contents are based on my understanding of HMRC legislation, which is subject to change.

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