First a WARNING… A STRICT WARNING – I would sincerely advise you all against investing in penny stocks. Do not invest in Penny Stocks if you do not have good knowledge.
One of the basic rules of buying stocks is to consider ‘value’; not ‘price’. But when the starting point itself is price, you are committing one of the fundamental investment mistakes. Unfortunately, however, the gambling instinct in humans is very strong. So despite knowing the risks involved and all sorts of warnings, people do get attracted to penny stocks.
The lure of hitting a jackpot is simply irresistible. So I decided to present five simple rules when investing in penny stocks and with some more research you can decide what stocks to buy and when.
If you choose to ignore my warning, kindly at least remember these rules. Going by the risk-reward ratio, the odds in penny stocks are heavily staked against the common investor.
While these rules will not guarantee 100% success with penny stocks, they will at least improve your odds. Learn to do value investing rather than just going on the price of the stock.
Why you should Invest in Stock Market?
Why you should Invest in Stock Market? The answer is simple – for Profits. Yes. Like any other investments you have to invest in stock market for only profits.
But, let me clarify your questions on why stock market is a viable option for investments. Share Market for many people is a gamble game. But in reality this is far from that. Stocks are also good investment option that can give you huge returns if invested meticulously. There are many other factors that makes stock market a good option of investments. Stocks can give great returns that no other asset class can give. All that you have to do invest wisely.
You can choose to do delivery trading or intra-day trading and you can trade in derivative segment or a cash segment. You can also get various choices in these. You can invest in dividend stocks for long term gains and enjoy the dividends or you can invest in growth stock for rapid gains. The best thing about stocks is you can choose any of these alternatives or a combination of them as per your budget.
Online trading has changed the face of investing completely. You can do the trading sitting at your desk by a single mouse click. Also, in online trading no paper work is required and no need of brokers. All that you need is fair enough knowledge on investing. Also, the online brokerage is very less when compared to the offline brokerages. To be precise, the online trading has made the stock market a profitable proposition to the individual investors.
Also, the internet shows you the quarterly and annul reports that are very helpful in doing research for judge the financial situation of the company to invest. The stock exchanges have become more transparent after new regulations and monitoring authorities at place.
Just because somebody lost money in stock market doesn’t mean that it is not profitable. Understand that when someone is loosing money, someone else is gaining it. It takes homework and smartness to be on the profitable side.
Use your common sense. If everyone looses money in stock market (or in case of any business), it wont be running for these many years. Do not take free advises. Do your own research. Invest smartly.
Invest only a nominal amount in Penny Stocks
It is psychologically comforting to buy a stock of say Company X priced at Rs.15/share, rather than Company A’s stock priced at say Rs.750/share.
Second, it sounds more logical and feasible to assume X doubling to Rs.30 than say for A to double to Rs.1500.And third, with small amounts of money (say Rs.15,000) you can buy more shares of X (1000) than A (only 20).
So even a Re.1 gain will give a profit of Rs.1000 in X and only Rs.20 in A. Therefore, low-priced shares appear to be relatively easier way of making money.
However, don’t forget that if it is easy to make 100% (or even more) profits in X, it is equally easy to even lose 100%. History shows that Rs.15 can easily become Rs.7.50 and you lose 50% of your investment in no time.
But it will be difficult for A to fall to Rs.375. (Moreover, being a good business, A will bounce back, while X may never). Hence, do not invest more than 3-5% of your corpus in penny stocks. Anything above 5% is committing hara-kiri.
How to make profits in Penny Stocks
One noteworthy problem with penny stocks is the lack of information – especially reliable information. In the absence of credible facts about the company, its management, operational numbers etc., it becomes difficult to make an informed judgement.
In such a scenario, choosing a penny stock is like looking for needle in a haystack. You have to really hunt for the stocks that are ‘truly’ undervalued.
With millions of investors, thousands of brokers and hundreds of analysts – whose daily bread & butter come from the stock market – it is very difficult for a good scrip to remain penny stock for a long time.
Only a seasoned day-to-day investor is in a position to detect such stocks before they are discovered by the market. You may have to study 20-30 companies (maybe even more) before you find something promising. Do not make any compromises here.
History of the Trading Volume
Let’s say you are lucky and X does go to Rs.30. Congratulations! You are sitting on 100% profits. But beware – when you go to sell, you may 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 (as we earlier saw 1000 shares of X) compounds 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.
Easy to Manipulate / Biased Recommendations
Unlike big stocks, penny stocks are more prone to manipulation. And, given that most of us buy merely on word-of-mouth recommendations (our fancy for hot-tips), the job of unscrupulous dealers become quite simple.
Do not get carried away by hyped-up media reports through newspapers, television shows, newsletters etc. Don’t go by casual remarks in the train or in the office or at the parties. You must do your own research… thoroughly.
Think twice – no thrice – as to why someone is recommending you an unknown stock if he is so sure of the company. Isn’t he likely to beg, borrow or steal to invest in that company rather than recommend it to you?
Thousands of investors have been duped in the past. Do you wish to be the next victim?
Do not – I repeat, do not – believe on any tips; especially with regards to penny stocks.
The myth of ‘It can’t go any lower’
There is usually a temptation to invest when the stock prices correct sharply and are suppose trading at 52-week low. We tend to believe that ‘it can’t go any lower’. This is not true.
If the company is facing serious business problems; or the promoters have siphoned away the money; or the manipulators have already made their riches, the stock price may never recover again. You can then forget your investment in that stock. In fact, over a period of time the stock exchanges will de-list that company so you can’t even trade in that stock.
Therefore, work with very strict stop-loss targets. Don’t live in hope.