5 Reasons Why Investing In Penny Stocks Is Risky
Even if you don't invest in the stock market often, you are likely to get calls and texts from unknown brokers trying to sell you penny stocks. What are penny stocks, anyway? On the US stock market, stocks that are trading for less than $1 are called "penny stocks." Penny stocks are usually stocks that are trading for less than Rs.20 in the Indian market. Another definition is stocks that are trading for less than their par value or face value. The main point of the story is that these penny stocks are shares of companies that most people have never heard of and whose business models aren't very good. Here's why you shouldn't fall for the allure of penny stocks, even if they look very appealing. As experienced share brokers we want to offers the best online trading platforms, and the best trading accounts for our users. 1. Penny stocks are cheap because they might not be worth much. Penny stocks are usually quoted at very low prices because that is what they are worth. Some penny stocks are sold as good investments because their P/E ratio is low. That can be hard to understand. The P/E ratio shows how much people trust and care about a stock, and a low P/E usually means that people don't trust the stock. Most of the time, these companies also use creative accounting to make their profits look bigger than they really are. Don't get tricked by a low P/E. 2. It's easy to trade in circles with them, and you could get caught. What does it mean to trade in a circle? Here, a group of brokers make a deal with the promoters to drive up the price of the stock by making fake demand for it. Most of the time, if A, B, and C are all trading in the stock, one of them will be either the buyer or the seller. But when the markets see that the stock is consistently being bought and its price is going up, a lot of small investors tend to become interested. As soon as there is enough interest from retail investors, these "circle traders" get out of the stock, leaving retail investors with worthless paper. 3. Penny stocks tend to move in areas that are doing well. This is where the game of penny stocks gets pretty easy. During the height of the technology boom, a lot of "fly-by-night" companies changed their names to sound like IT companies. Not only did these companies manage to get people interested in the market, but they also sold shares in their IPOs and private placements at prices that were too high. You don't realise you've been taken for a ride until the dust settles. 4. Volumes can be created and taken away quickly. This is something that happens a lot with these cheap stocks. You may buy a stock because it has a lot of trades, but as soon as you do, buy orders are pulled. What is going on? Let's get back to our question about penny stocks and how they are traded. Most of the people who buy and sell at the counter are the same people who do business in circles. When they see that retail buyers are pushing prices up, they will just cancel their buy orders at lower prices. This makes the selling/buying order book look off, which makes people want to sell more. This is bound to happen when only a few traders control most of the volume. 5. Illiquidity is a major risk This again has to do with the last point. What does the term "basis risk" mean? It is the difference between the buy price and the sell price, also called the spread. This is important because it makes your costs go up when you buy and makes your advantage go down when you sell. You'll also notice that these stocks are always in the lower circuit or in the upper circuit. Since the volume and float are completely controlled by the circular traders, it may become very hard to buy and sell the stock. Most of the time, they will continue to be interested in these stocks only after they have sold all of their stock to other investors. 6. A lot of them could be "shell" companies Most of the time, these companies whose stocks are worth only a penny are just "shell" companies. That means that the company is no longer doing business or that all of its assets have been taken away. At the end of the 1990s, there were a lot of software companies that were really just fronts for laundering money through exports. Such businesses have a negative enterprise value, so it doesn't make sense to buy them at any price. Worse, if SEBI starts an investigation into one of these companies, you may have to answer embarrassing questions as well. Last but not least, you don't have to do that with your hard-earned money. Lastly, buying penny stocks is probably not the best use of your hard-earned money. These stocks are high risk and have a low chance of making money. Most of the time, they are just tricks to get people to buy. Instead of buying these penny stocks, you would be better off buying shares in good companies that have been well researched. Remember that the market is full of stories about how your neighbour became a millionaire by investing in penny stocks. But there are also stories of people who put everything they had on penny stocks and lost everything. Penny stocks are not worth taking a chance on. You can do a lot more with your money. Better to be safe than sorry! As experienced share brokers we want to offers the best online trading platforms, and the best trading accounts for our users at all times.