If you’ve had the fortune of watching hit-movie the Wolf of Wall Street, then you might remember Leonardo Di Caprio selling thousands of dollars worth of penny stocks to an investor over the telephone. If you are wondering what they are and how they work, then we’ll explain everything you need to know.
In our ‘What are Penny Stocks?’ guide, we’ll start by explaining what penny stocks are, followed by a discussion on why they are so different to more established blue chip stocks.
This will include a thorough overview of their underlying risks, as well as their potential as a high-growth asset class.
Let’s start by exploring what penny stocks actually are.
What are penny stocks?
In a nutshell, penny stocks are shares in companies that operate outside of major stock markets such as the FTSE, Dow Jones and NASDAQ. Although they are referred to as ‘penny’ stocks, shares can still fall within this bracket of asset class as long as they are worth less than $5 a share, as per U.S. based the Securities and Exchange Commission.
Previously, and as the name suggests, a penny stock had to have a value of less than $1 per share. Penny stocks are extremely speculative, high-risk and thus, are at the very top of the ‘High Risk, High Return’ spectrum.
As we will explain in more detail further down, this is for a number of key reasons. This includes small market capitalizations, which in itself results in low liquidity levels and extremely wide spreads.
Moreover, as the buying and selling of penny stocks is most commonly facilitated via the pink sheets or in the form of the OTC (Over the Counter) markets, there can also be issues when it comes to selling your penny stocks at a later date.
Let’s break these risks down in the more detail.
First and foremost, penny stocks are not accustomed to the same regulatory standards as seen in other stock markets such as the FTSE or Dow Jones. As such, while it is true that companies that supply penny stocks must still engage in regular public reporting with respect to financial performance, business activities and management, this is significantly less elaborate than a blue chip stock.
For example, large companies operating on major exchanges will not only release information themselves, but third party media platforms will also be heavily involved in the release of information. On the contrary, as penny stocks are essentially ultra-small firms operating in a private manner, information is not only minute, but at irregular intervals.
Thus, crucial changes may have occurred within the penny stock company you have backed, but the information might not reach the public domain.
Small Capitalization and Extreme Volatility
Due to the environment that they operate in, penny stocks usually have an ultra-small market capitalization. For those unaware, market capitalization equates to the amount of shares in circulation, multiplied by the current value of the share.
If there were 1 million penny stocks in circulation at a current market value of $0.10, then the company would have a total market capitalization of just $100,000.
To put things in to perspective, the OTC Markets Group, which alongside the Pink Sheets is one of the largest marketplaces to buy and sell penny stocks, has a total market capitalization of $435 million at the time of writing.
In comparison, the FTSE 100 has a market capitalization of more than £2 trillion, illustrating a significant disparity. Moreover, at the time of writing, in 100th place in the FTSE 100 market capitalization rankings is the Marks and Spencer Group, which alone sits at more than £4 billion!
If you are wondering why this matters, one such concern is volatility. When companies have a small market capitalization, price movements are often substantially more volatile than those which large caps, not least because a single purchase or sale of penny stocks can cause the price of the asset to rise or fall significantly.
While high volatile markets are a major concern, penny stocks facilitate an even greater risk – liquidity.
One of the biggest risks to investing in penny stocks is that liquidity levels are extremely low. Liquidity refers to the amount of cash currently sat within a particular marketplace for a particular stock.
As such, it dictates how easy or difficult it is to quickly buy and sell an investment. In large marketplaces such as the FTSE, liquidity levels are ultra-high, meaning that you will never have a problem selling your shares.
On the other hand, liquidity levels in the penny stocks space is often minute. This means that while it might be simple to purchase penny stocks, you might face difficulties finding a buyer at a later date.
If this does occur, then you might be forced to sell your penny stocks are a significantly lower price than the actual market value.
An additional risk to the penny stocks arena is that of the spread. In the financial markets, the spread refers to the difference in price between the current bid, with that of the ask price. In layman terms, the spread is the difference between the highest price that a buyer is prepared to pay for an asset, and the lowest price a seller is willing to sell their asset.
In major stock markets, the spread is really low, meaning that investors will rarely have to sell their shares below their underlying value, not least because there are significant levels of buyers and sellers in the market.
On the contrary, many penny stocks available in the market have a very high spread. What this means is that when it comes to selling your penny stocks, you might need to accept a highly unfavorable price.
Some commentators put the average penny stocks spread at a substantial 25-33%, although this can at times be as much as 50-100%!
Thus, although you might experience double-digit growth, when it comes to actually cashing out your penny stocks, much of this profit can be eaten away by the large spread.
So now that we’ve covered some of the main risks associated with penny stocks, in the next section we will discuss the motivating reasons for actually making an investment.
If the Risks are so High, why do People Invest in Penny Stocks?
You are probably asking yourself why on earth an individual would invest in penny stocks if the underlying risks are so inherently high. Essentially, and as noted earlier in this guide, although penny stocks are highly speculative, they also offer the chance to make considerable gains.
The effects of high volatility, low spreads and small market capitalization levels can of course go against an investor, however at the same time, they can also work in your favor. In other words, it is not unusual for a penny stock to increase in value so considerably than it no longer is a penny stock, meaning that is surpasses the $5 mark.
Taking this into account, penny stocks are only suited to a certain type of investor. Not only must you have a full understanding of the underlying risks, but you must also recognize the fact that your investment could be lost in its entirety.
Although it is true that one only needs to look at the likes of the Layman Brothers to understand that blue chips stocks are not completed immune to collapse, the likelihood of this occurring is extremely low.
However, in the case of penny stocks, it is potentially more likely that you will make a loss long-term, not least because success stories are so rare.
On the other hand, you only need one successful pick to see your penny stocks rocket, although one again, this is more than of a mere possibility than a probability.
Recent example include the likes of Domino’s Pizza, Mulberry and even ASOS, which although going through a turbulent time at present, still has a share price of 2,991p.
So now that you know why penny stocks investments are made, in the final section we will explore how you can actually purchase them.
How do you Invest in Penny Stocks?
Although it can be done, investing in penny stocks is significantly more complex in comparison to a company listed on major stock exchange such as the FTSE. Unless you are a seasoned private investor with personal experience of the OTC markets, then it is likely that you will need to go through a broker.
However, it is also worth noting that some penny stocks are actually listed on the UK-based AIM. If this is the case, then you stand a much better chance of making a purchase.
Your best bet is to perform research on where your chosen penny stock is listed, and then find a broker that has access to the marketplace in question.
In fact, performing research on the individual broker themselves is just as important as the research you conduct on the penny stock. The key reason for this is that the penny stocks space can at times feel like the Wild West, and thus, attracts unscrupulous brokers who do not have your best interests at heart.