The higher the potential return on an investment the higher the risk; so is the case with Penny stocks. As the name suggests, ‘Penny Stocks’ are those stocks which are available for pennies in the open market. These stocks are usually available at prices as low as 1/10th of their face value and hence have a higher probability of big windfall gains than the stocks of any blue chip company.
For instance, let’s take the example of SRK Industries Ltd (ISIN: INE951M01011). On this day, one year back, their shares were trading at Rs. 3.04; while the same price is worth Rs. 328.30 today. Well, that would be about 10,699% return on your investment.
There is literally a LOT of risk associated with Penny stocks. But if you still find Penny Stocks a very lucrative form of investment, keep in mind the following important points before you decide to invest in them:
1) Do your homework. Do an extensive research on the company and try getting as much information about the company as possible. Unlike big stocks, penny stocks are more prone to manipulation. And, given that most of us buy merely on word-of-mouth recommendations, the job of unscrupulous dealers become quite simple. Unlike other companies, it is very difficult to gain information on the performance of penny stocks. Try attending their Annual General Meetings and follow the company’s news in any way possible.
2) History of the trading volume. Say you invested in some company, you got lucky and now your investment has tripled and now are jumping with happiness. But wait a second – when you go to sell, you may actually not find any (or sufficient number of) buyers.
Penny stocks are normally illiquid. A large part of the share-holding is owned by the promoters who may readily be willing to be sellers. But when it comes to buyers, you won’t find many of them.
The fact that you tend to buy more quantity since the price is cheap multiplies the problem. Selling even 100 such shares is difficult; so selling large quantities is virtually impossible.
As such, it would be prudent to study the trading volume very closely for last 6 months to 1 year to check whether it is consistently high. Uneven spurts in volume could be signs of manipulation and not high liquidity. To be on the safer side, never invest more than 10% of the stock’s daily volume.
3) NEVER Short-Sell. Say you short sell a share of X Company at the price of Re. 1. Currently, the maximum you stand to gain on your investment is 100% (i.e. if the share price goes down to 1 paisa). But on the other hand, the percentage of your investment you stand to lose can be much more than just 100%. By short selling, you are exposing yourself to very high risk for a return which is comparatively very small.
4) Know when to exit. Penny stocks are not meant for long term investments and hence the best way to earn on your investment in them is by exiting early. Make sure you are sure what your Stop Loss Limit and Profit target is.
Many (almost all) financial advisers have classified Penny stocks as the worst form of investment as the risk associated with them are very high. But as Jim Rohn once said, if you are not willing to risk the unusual, you will have to settle for the ordinary.
On a more responsible note, I would urge you to research a lot more as the biggest risk you can ever take while making your investment is having lack of knowledge in it.