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The name 'penny stocks' was originally given to stocks that had a share price of less than a pound. These days the term has been expanded to cover stocks that are valued over a pound as well, but generally penny stocks have low share prices. They are usually characterised by high volatility and are seen as high-risk stocks but with the possibility of significant growth.
The appeal of penny stocks and shares is easy to see. If you have £1000 to invest, you can get so many more shares in a tiny company whose shares are trading for a few pence, rather than buying blue chip shares which may cost many pounds. And of course, if your penny share one day goes on to join the blue chips, you will end up making many hundreds of percent return. If we add into the mix the folklore of a friend of a friend of a friend – or to bring it more up to date, someone on the internet – who made a million or more from penny shares, their appeal is cemented.
But before you get caught up in the thrill of penny stocks, take a breath and a step back. Penny shares are normally penny shares for a reason – they usually don't make very good investments. The company may have been losing money for years, or it may be in a highly speculative industry (mining is always a popular one). If its success depends on landing one major contract or finding diamonds in an obscure part of the world, then you have to weigh up the likelihood of that actually happening, and the risk of what happens to your investment if it doesn’t.
The penny share speculator needs to go in with their eyes open. The suggestion to do your own research is often quoted when it comes to investing in stock markets, and is probably even more true of penny stocks. As they tend not to see too much daily volume on stock markets, it often doesn't take a large buy or sell order to move the price. If plenty of people are talking about a penny share down the pub or more likely on internet chat rooms, that can also influence the price. It's important not to get sucked into an investment just because it has had a large one-day move and you are afraid of missing out. What goes up quickly can come down even quicker – so make sure your reasons for investing are the right ones.
Although penny shares are cheaper per share than the major companies, the costs can end up being more, as a percentage of your total investment. All markets have a bid/offer spread – a price you buy at and a price you sell at. In so-called blue chip shares this spread is very tight – the difference between the buy and sell price will often be less than 1%. But in lower volume penny shares, this difference may be 5%, 10% or even more. This means the penny share has to rise more for you to actually make a profit. It can mean that if you change your mind very quickly about the investment, you end up taking a bigger loss than you were banking on. This is another important point to consider when trading in penny stocks.
If you are happy with your research and have gone ahead and made your investment, another key point is: don’t forget to sell! For example, let's say you are fortunate and the value of the penny stock moves in your favour and, for the sake of argument, let’s say it doubles. It can be very easy to sit back and wait for it to double once more. That can always happen of course, but you need a plan to get out and have some profit if it doesn’t. When sentiment changes on smaller shares it can perform an about-turn very quickly, taking all of your hard-won profit, and maybe more. Getting in to the position is only half the plan of investing, in fact some would say it actually accounts for less than that. Where you get out will determine just how successful penny stock trading will be for you.
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CMC Markets does not endorse or offer opinion on the trading strategies used by the author. Their trading strategies do not guarantee any return and CMC Markets shall not be held responsible for any loss that you may incur, either directly or indirectly, arising from any investment based on any information contained herein.