Dubai: Because of the old adage “it takes money to make money”, many still think of investing and the stock market as an activity for the wealthy.
But what if you could start investing with stocks that cost Dh1 or lesser even? This is where the concept of investing in penny stocks has become increasingly popular. Here we outweigh the perks, alongside key risks.
In general, penny stocks have lower trading volumes compared to regular stocks, and this lack of liquidity means it may be more difficult to sell a stock when you want to. They also suffer from large price fluctuations, so any bit of news will cause a penny stock's price to rise or fall.
Briefly put, are penny stocks a wise investment?
“Briefly put, penny stocks are risky and there's not a lot of information available on most stocks that trade in such a manner,” said Brody Dunn, an investment manager at a UAE-based asset advisory firm.
“These stocks truly can turn a small amount of capital into a huge sum of money pretty fast, but can just as quickly wipe that investment out. One needs to also look out for scams involving penny.” But the question remains as to why then are still so many making profits with penny stocks?
Why are investors still investing in penny stocks?
Although penny stocks are high-risk securities with a small market capitalisation that trade for a relatively low share price, typically outside of the major market exchanges, in reality, many newbie investors still opt for such stocks in hopes of making quick profits.
“Investors, however, continue to open accounts with top discount brokers who offer these high-risk investments in hopes of making the right picks,” said Dunn. “Experienced investors might hold the stock for 6 minutes or up to 6 months. If you trade daily, you may buy and sell them every five or 10 minutes.
“But, investors who are looking for long-term plays and do not want to trade much off momentum, might hold penny stocks for as long as six months. But the longer you hold to such an asset increases your risk of losses just as much as it increases your chances at a high return or profit.”
Penny stocks are risky and there's not a lot of information available on most stocks that trade in such a manner
Are there any perks to investing in penny stocks?
Most penny stocks have tiny market capitalisations, meaning it only takes a small amount of money to move their share price substantially.
Therefore, any positive news related to the small company can lead to sizeable returns. Conversely, negative news can lead to significant losses.
Penny stocks attract investors with a small amount of trading capital as their lower share prices allow them to buy thousands of shares.
For example, if an investor has Dh500 to invest, they can purchase 2,000 shares of a penny stock trading at 25 fils. If that stock doubles over a month, the investor makes a quick 100 per cent return on their investment.
However, with the same starting capital, the investor could afford only a small number of shares in most other stocks, making it almost impossible to achieve those gains over the same period.
What are the other key risks of investing in penny stocks?
“As penny stocks often trade on thin volume, it can be difficult for investors to enter and exit their positions,” added Dunn. “Moreover, these stocks typically have a wide spread between the bid and ask, which increases trading costs.” But what does this mean?
For example, if a penny stock has a bid price of Dh1 and an ask price of Dh1.50, a trader wanting to buy at market gets caught paying a 50 fils-per-share premium. “Therefore, investors should use limit orders to minimise trading costs when buying and selling penny stocks,” advised Dunn.
“Penny stocks that start moving rapidly higher in price show up on stock screeners and may even get media attention. This often attracts more speculators who push prices up even higher, leading to unstainable valuations,” he further explained.
How else can I profit when I buy volatile penny stocks?
The stock market is always changing and it can be hard to keep up with the latest trends. But if you gauge what is happening in the market, you can make most of volatility and make money with penny stocks, suggests Kashyap Singhania, a market trading analyst with nearly three decades of experience.
Here are three things Singhania advises investors to look for when trying to understand stock market trends:
• Look at the overall trend of the market. Is it going up or down?
• Look at the sector that the stocks are in. Some sectors are more volatile than others.
• Look at the individual penny stocks. Some stocks are more volatile than others.
“By understanding these three things, you can start to take advantage of stock market trends and make money with penny stocks. In addition to this, we have micro and macroeconomic trends. This includes everything from the political situation to smaller upsets in the market,” he added.
But in reality, it’s not always so simple to make profits
While some factors will impact some penny stocks, others may not be so obvious. This is why it’s important to do your own research before investing in any stock, penny or otherwise, market investors reiterate.
“When you have a good understanding of the market and what stocks are worth watching, you can start to take advantage of volatility and make money with penny stocks,” said Singhania.
“However, always remember to do your own research before investing in any stock. Stay up to date on the latest market trends, and you’ll be well on your way to making money with penny stocks.”
Bottom line?
If you’re thinking about investing in penny stocks, the first step is to understand your risk tolerance, market investors reiterate. This will help you choose the right stocks to invest in and avoid losses. There are four main types of risk tolerance: conservative, moderate, aggressive, and speculative.
Moderate investors are willing to take on some risk in pursuit of higher returns. They’re comfortable with stocks that are somewhat volatile and have the potential to generate good profits.
Aggressive investors are typically more risk-tolerant than moderate investors. They’re often willing to invest in stocks that are highly volatile and may not be suitable for all investors.
Speculative investors are the most risk-tolerant of all investor types. They’re often willing to invest in stocks that are extremely volatile and may not be suitable for anyone but the most experienced investors.
If you’re not sure how much risk you can take on as an investor you are, Singhania advised considering the time frame in which you plan to invest.
“Short-term investors are typically more aggressive than long-term investors because they’re less concerned about preserving their capital. In the end, considering your risk tolerance is an important part of making money with penny stocks.”
