Investing: The Basics of Penny Stocks

Penny stocks, despite the seemingly obvious name, are not always worth one penny. In fact, penny stocks are any share of stock that stays below five dollars in value per share. Most are quite volatile. This can draw or repel an investor, depending on investment goals.

There are two main types of investment strategies – going long, and going short. This is not to be confused with selling short. Short selling is something different, but technically this is only a difference of degree and not kind.

Going long (also known as the buy-and-hold tactic) involves buying a stock and keeping it for as long as possible. This strategy is based on the fact that the stock market always ultimately goes up. Even accounting for times of depression or recession, such as the 1930s or 2000s, eventual growth is always assured. Of course, while the entire stock market always ultimately gains value, this does not mean that all individual stocks do. The stock market is much like the body of a living organism. While the entire body might live and grow, individual cells might grow, live for a little while and then die. In the same way, individual companies might increase or decrease in value, or even go completely out of business, regardless of what the rest of the market is doing.

Stocks held over a long period of time (such as a decade or two), tend to mimic the market. That is, they go up and down when it does (although perhaps not the same amount). This means that going long is generally not profitable in times of recession. For example, people with the buy and hold strategy who purchased their stocks in 2000 consider the next ten years the “lost decade”.

However, the buy and hold strategy is not the only way to make money in the stock market. For many investors, the 2000s were not a lost decade at all. Volatility can also be a great source of profit. For skilled investors, more money can be made from buying, selling, re-buying, and re-selling a stock than simply buying a cheap stock and holding it through thick and thin.

Penny stocks are often sought by skilled investors for two reasons. One is that since they are cheap, the possibility for growth is practically unlimited. Finding the right penny stock that eventually gains ground and becomes anything but a penny stock can translate to gaining a fortune. But the real allure is their volatility. Penny stocks are not subject to the same regulations as stocks priced at five dollars. Because of this, their prices can fluctuate much more wildly and unpredictably than higher priced stocks. Day traders and other short-term investors can take advantage of this by buying high numbers of cheap stocks when they are cheap, and short selling them after they increase in price.

But, penny stocks are not a magic bullet to prosperity. The lack of regulations that cause a high amount of volatility with micro caps also translate to a higher amount of risk to investors than other stocks typically carry. For example, some stock values are often artificially inflated when an investor buys up huge amounts of them at one time. Then, when the value has increased significantly, the investor sells them all at once. Because of how supply and demand works, this tends to cause a sharp drop in price, meaning that anyone else who has the stock takes a loss.

Furthermore, penny stocks are sometimes less liquid than other stocks, meaning that selling them is often difficult or time-consuming. This means that if a company does begin to take a sharp dive, it may be hard to liquidate one’s holdings and cut losses.

In short, penny stocks carry more risk than blue-chip stocks. This risk can translate to increased gains, by taking advantage of greater market volatility, but can also lead to financial loss if other investors of one’s chosen stock are using a pump-and-dump strategy. The importance of doing one’s homework and analyzing the stock in question cannot be stressed enough.

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