There are different classifications of stocks that you’ll find in the stock market, and one of them is penny stocks.
Stocks are one of the most known instruments of investment and trading. They act as a way to own a part of the company while also earning profits and incurring losses. There are ups-and-downs in the stock market, something that you should always keep in mind when entering any financial market.
Aside from classifications, there are various ways you can employ when dealing with stocks which includes short selling.
Some methods are more profitable than others. But the best way to learn which is which without the risk of losing too much is through research. You must first find out as much as you can about these two before diving into it.
So, let’s help you learn more about what penny stocks and short selling actually are.
What are Penny Stocks
Penny stocks are usually found outside of the major stock exchanges. Other than this, it also trades at a relatively low price with smaller market capitalization.
These stocks are generally considered highly speculative and high risk due to various factors. Factors include disclosure, large bid-ask spreads, lack of liquidity, and small capitalization and limited following. Penny stocks are most often traded through the OTC Bulletin Board (OTCBB) and pink sheets.
In the past, the term penny stocks address stocks traded for less than a dollar per share. However, the Securities and Exchange Commission (SEC) has changed this and included all shares that trade below $5.
Despite most penny stocks trading outside the major market exchanges, there are still some large companies, based on market capitalization, that trade below $5 per share found on main exchanges such as Nasdaq.
If you have high tolerance for risk, then penny stocks is for you.
Penny stocks tend to have higher levels of volatility. This results in a higher potential reward but with higher level of risk. You should then take precautions when handling penny stocks, such as a predetermined stop-loss order.
See also: How to Overcome Volatile Markets
Having realistic expectations is also important when it comes to investing in penny stocks. Even though penny stocks sometimes have explosive moves, it doesn’t mean that you’ll immediately get richer. If you enter the market with a small investment capital and expect it to grow tenfold within a few weeks, then you’re in for a surprise.
You should keep in mind that usual gains in the stock market take months and years to materialize.
Example of Penny Stocks
Here are some examples of penny stocks found inside and outside major exchanges:
- Curis Inc. – 0.98 USD
- Orexigen Therapeutics Inc. – 0.33 USD
- Quaterra Resources Inc. – 0.0601 USD
- Zynga Inc. – 3.75 USD
- Antares Pharma Inc. – 2.78 USD
- Joe’s Jeans Inc. – 4.33 USD
- Synergy Pharmaceuticals Inc. – 2.14 USD
Risks of Penny Stocks
There are two problems presented by the absence of liquidity in stocks. One is that you might not be able to sell the stock, and two is the possibility of some traders manipulating the stock prices.
Liquidity is the degree of which an asset or security can be bought or sold without affecting its price. Let’s put it this way: cash is considered to be the standard for liquidity since it can easily be converted into other assets. If you would want to buy a new TV, it will be easier to trade your cash for it.
But if for instance, you lack cash and instead have something else of equal value, you might still not be able to buy the TV with it. You would be better off selling what you have in exchange for cash. Still, if you need to buy the TV as soon as possible, you might need to concede and sell your item for lesser value in order to sell it faster and gain the cash you need to buy the TV.
Note that, low level of liquidity might force you to lower your selling price until considered attractive to other buyers.
2. No Minimum Standards
There are no minimum standards needed to be fulfilled when stocks enter the OTCBB and pink sheets. This is mostly the reason why stocks are found on one of these exchanges. When a company can no longer maintain its position on the major exchanges, it moves to a smaller exchange.
The OTCBB still require the companies to file timely documents with the SEC. However, there are no such requirements with the pink sheets.
Minimum standards are of importance since they act as a safety cushion for some investors. It also acts as a benchmark for some companies.
3. Lack of Public Information
Doing research and gaining enough information to make informed decisions are important factors to attain success in investing. But it can prove to be a harder task to accomplish when investing in micro-cap stocks.
Pink sheets don’t require companies to file with SEC. This makes companies less scrutinized by the public or not as regulated as those found on the NYSE and Nasdaq.
It’s also important to note that information readily available about micro-cap stocks are not taken from credible sources.
4. Lack of History
There are numerous micro-cap stocks found in the market. Most of these stocks are either newly formed or nearing bankruptcy. You’ll see that these companies will normally have poor track records if any.
Lack of historical record can make it harder to see whether the stock has potential and if it’s worth it.
What is Short Selling
Short selling is one of the methods used in dealing with stocks. This is when you sell a security that you do not own or have borrowed and then buying them back at a later date.
When you short sell a stock, you are betting that the stock will decrease in value so that you can buy the stock back in a lesser value, ergo gaining profits.
Most investors decide to short sell to hedge the downside risk of a long position in the same security or a related one. It serves as a way to speculate if you think that a market’s value is about to decline. You should also note that short sales can only be undertaken in margin accounts.
Short selling can potentially cause a company to file for bankruptcy.
Let’s say that you and other investors decide to short sell the asset of a certain company. This can affect public confidence since it suggests that traders think the share price will soon plunge. Stockholders will then be encouraged to sell their stock, causing the price of the asset to plummet.
It is highly suggested that you take on short selling only if you are an experienced trader. This is to ensure that you’ll be able to handle the infinite amount of risk that comes accompanies short selling.
Pros and Cons
- Short selling can lessen volatility and can instead increase liquidity in the market.
- It can lead to a better pricing as well as a more orderly market.
- Investors who practice short selling have the chance to reduce the risk of market crashes. This can be achieved by adding a normal element of pessimism to stock prices.
- It’s one of the few ways to make money even from a downbeat or bearish market.
- There are unlimited potential risks for short selling. You need to be ready in case the market goes against your way by adding a stop-loss to your position.
- Short sellers face a roadblock in the form of the best dividend paying stocks. You wouldn’t be able to reap benefits from stock dividend payments since you’re betting against the stock without actually owning it. You will then need to pay the lender any dividends declared during the time that the stock is loaned to you.
- You’re speculation can end up being the opposite of what actually happens. You might then end up having to repurchase the stock at a much higher price than before.
- There are also other corporate actions, like stock splits or bonuses that you will have to pay to compensate the lender.
- The margin interest payable in short trades can accumulate over time, especially if short positions are held over an extended period.
Short Selling Penny Stocks
There are many traders that consider short selling penny stocks as a great opportunity to earn profits. But there are risks that you should first consider before you go through with it.
There are margin requirements that a broker will require you to put up. This will act as collateral to guarantee against any potential losses.
Aside from this, you will also have to find the stock that you want to short sell. Even if you do find a share that is great for short selling, if you don’t acquire the said share, then it’ll all be for nothing.
You also run the risk of market manipulation. It has always been a huge issue in the world of penny stocks but can become an even bigger threat when you are short selling penny stocks. This is because the losses you might incur are unlimited.
Before you decide to pursue short selling or investing in penny stocks, make sure that you are well-prepared. There are numerous ways for your investment to go downhill so first consider all the benefits and detriments that you can incur.
Find out as much as possible about any action you’re about to do before proceeding with it. Keep in mind that you’re not only risking your money but also yourself.
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