Penny Stocks: what they are, how they work and how to invest

The general sentiment among investors who buy penny shares is that they are betting on a small-cap company that will grow over time. This carries an added element of risk, but some believe it also offers higher returns.

Are penny shares more volatile?

Penny shares are often more volatile than other stocks because they belong to very small or recently listed companies.

As a result, they are sensitive to news and market developments, as well as having limited liquidity. On the other hand, this means that they can benefit from greater growth opportunities.

Since penny stocks trade at low prices, an upward movement in their value can quite easily translate into a large percentage change in their price.

Precisely because they tend to be more volatile, there is greater risk associated with purchasing or trading these securities. You should always take risk management measures when trading or investing in penny stocks.

Risks and returns of penny shares

There can be considerable risk when trading penny stocks, greater than that associated with placing in larger companies. However, there are also potential returns:

  • it may happen that stocks are undervalued (since they belong to small companies), which results in a greater margin for growth in the share price;
  • you can gain exposure to a large number of stocks at a relatively low price;
  • the high volatility creates opportunities both in terms of traditional trading (buying) and for short selling;
  • penny stock companies don’t always have a proven track record of success;
  • penny stock companies tend to be small and at risk of failure;
  • the length of time it takes for traders and investors to realize profits may be longer when trading penny stocks versus larger stocks;
  • there is often a risk of price manipulation.

Penny shares and risk management

Since penny stocks are particularly volatile, a sound risk management strategy must be in place. This management may include adding stops and limits to your position, to ensure possible gains and limit any losses.

A stop order is a tool that sets the conditions for closing a position when the market price drops below a certain point. Therefore, if the market price moves towards a less favorable point, the stop is triggered and the position is closed to avoid further losses.

You can choose between normal stop and guaranteed stop. The latter, if activated, involves a commission as it also protects against any price jumps.

You can also set limit orders, which open a position (buy or sell) at a more favorable price than the current market price. You can also place a limit order to avoid monitoring the markets, while still executing trades based on your preferred parameters.

How are penny stocks offered to the public?

Penny stock companies that meet the basic requirements to go public go public through an Initial Public Offering (IPO) or through a SPAC.

An IPO is a long process involving accounting checks, evaluations and various recordings. News of an IPO is published a few months before the expected listing. You therefore have time to study the company’s financial data.

A SPAC, “special purpose acquisition company”, is a shell company that raises capital on the stock exchange to merge with a private company and thus become a fully-fledged publicly traded company. In some cases, a company can skip the entire process by going directly on the stock exchange.

You can use our IPO trading platform to identify the next company that needs to raise capital to increase profitability.

You can learn how to trade an IPO before you decide to invest capital. We have a list of upcoming IPOs that you can compare, and decide to trade with if you think they are promising.

Read also: When do global stock exchanges open and close?

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