What are penny stocks?
A penny stock is a company that trades for less than £1 a share in the United Kingdom, or lower than $5 in the US.
Just because these penny stock companies have low share prices, doesn’t mean all of them perform poorly – many drive the price down by issuing new shares as the price climbs.
Since shares represent control over a company, a business can prevent itself from being taken over by a majority shareholder by issuing new shares.
However, some penny stock companies can be smaller and less frequently traded, which can sometimes result in less liquidity. That means you could potentially have a harder time offloading shares when you come to sell them.
It’s important that you keep an eye on the liquidity of a penny stock company if you want to invest in it. Wider bid spreads, which is the value that the asking price exceeds the bidding price for shares, are typically more common with penny stocks thanks to this liquidity.
Since UK penny stocks are traded over-the-counter (OTC stocks), they are typically traded on the alternate investment market (AIM) of the London Stock Exchange.
Some of the best penny stocks are household names, such as Lloyds Banking Group and Cineworld, while others you may not have heard of, such as Greatland Gold or AFC Energy.
You can find out more about some of the best penny stocks you should keep an eye on later in my guide.
What risks are involved with penny stock trading?
Penny stocks are usually considered high-risk investments compared to other, more traditional forms of investing.
Lower liquidity and higher volatility can cause investors to potentially lose their entire investment due to swings in stock prices.
This is why penny stock traders will often use stop-loss limits on their orders. Stop-loss orders allow you to input a particular value for how low you’re willing to let your investment fall in value. If your penny stock then reaches this value, it will automatically be sold to limit your losses.
You should also keep in mind that there’s typically less available information about penny stock companies. Unlike a well-established blue-chip company, it can be trickier to find reliable industry news or corporate performance information surrounding the company.
Without adequate information about a company, you may find it difficult to gauge how its price could move on the stock market, and whether they have any important milestones approaching that could influence the stock price, like the release of a new product.
As mentioned, penny stocks tend to have lower liquidity, which can open them to manipulation. For example, the “pump and dump” scheme involves tricking investors into buying large quantities of shares, which drives the price up on the stock market, attracting more investors. When the stock price has been artificially increased, the scammer will then sell all their shares for a good price.
The different ways you can invest in penny stocks
When you first think of investing in penny stocks, chances are the first thing that comes to mind is purchasing shares normally from stock exchanges.
Though, you may be surprised to hear that there are several different ways you can invest in both UK and international stocks. So, continue reading my guide to find out the various ways you can invest, and which would best suit you.
Purchase shares individually
As the name suggests, purchasing shares individually involves buying penny stocks through your broker.
You can then sell your shares at a later date when the price has increased in order to turn a profit. Or, if the company offers dividends, you can hold onto your penny stocks and rely on dividend payments.
However, it’s worth noting that not all penny stock companies offer dividend payments since they tend to be smaller companies with less revenue, or larger companies going through financial issues.
Gain exposure through a fund
You can also get exposure to a variety of different penny stocks through a fund.
A fund is a type of pooled investment in which money is accumulated from investors and subsequently reinvested in many different companies.
Funds are usually overseen by fund managers, who are typically experts in their field. Since fund managers will try to spread risk by diversifying funds, you are gaining instant diversification by investing in one.
The share value of the fund then depends on the performance of its constituent companies. If the value of its investments increases, so does the value of the fund.
Much like trading individual shares, you can either invest in a fund and wait until the price has increased then sell your units, or you can hold onto them and rely on dividend payments.
You typically have two options when you’re looking to invest in a penny stock fund: you can either find a fund that includes your desired company, or one that specifically tracks penny stock companies.
Some examples of specific penny stock funds could be the iShares Micro-Cap ETF, or the First Trust Dow Jones Select MicroCap Index Fund.
You should keep in mind that when you invest in a fund, you may face higher costs and charges. And, since penny stock funds are usually actively managed, you are compensating the work of the fund managers who are overseeing the fund.
Trade derivatives
Now, this is where things tend to get slightly complicated. Instead of directly investing in penny stocks, or gaining exposure to them through a fund, you may want to try your hand at derivative trading.
Before you do so, it’s important to note that more than half of retail investor accounts lose money when trading CFDs since they are considered high risk, so you should ideally do plenty of research before you attempt derivative trading.
There are a couple of different ways you can start trading derivatives, so if you’re wondering how spread bets or CFDs work, read on to find out how the two methods differ from one another.
Spread betting
Spread betting involves “betting” on the movement of a company’s share price.
When you open a spread bet position, you will usually state whether you believe the company will increase or decrease in value.
You then “stake” money on this position, and every point of movement will affect your payout.
For example, if you were to stake £100 for every point of movement for a penny stock company, and the company’s value did indeed move by two points in the direction you predicted, you would earn £200.
Of course, if the company’s value moved two points in the opposite direction, you would lose £200.
CFDs
“Contracts for difference”, or CFDs, differ slightly from spread betting.
With CFDs, you will instead receive the difference in price from when you opened your position.
When you first open a CFD position, you are given a “margin”; this is the percentage of the investment you actually have to pay. So, if you wanted to invest £1,000 in CFDs, but the margin was only 5%, you would only need to pay an upfront investment of £50 to your broker.
If you opened a CFD position stating that the value of a particular company would increase, and it did indeed rise from £10 to £15, then you would turn a £500 profit without needing to pay the initial £1,000 ask.
Of course, if the value of the above company fell from £10 to £5, you would be required to pay the broker the £500 difference on the margin.
This is why trading CFDs can be particularly risky – if you make many different deals at once, and they don’t go your way, you could end up losing a lot of money.
Of course, the values in the above example will differ slightly when you trade penny stocks, but it can still be easy to accumulate losses quickly.
As has been previously mentioned, it’s vital you keep in mind that derivative trading is very complex and is considered high risk – so much so that more than half of retail investor accounts lose money when trading CFDs or spread betting.
What is the best way to invest in penny stocks?
The best way to day trade penny stocks wholly depends on your reasons for investing in the first place, and your experience levels.
For example, if you’re still new to penny stock trading, you may want to consider investing in companies directly or gaining exposure to them through a fund.
Or, if you’re more experienced with penny stock trading, or you’ve tried your hand at derivative trading before, you may want to consider spread betting or CFDs.
Similarly, if you are investing for an income rather than growth over a longer period of time, individual shares or funds may be the option for you.
How to start investing in penny stocks
So, now that you know exactly what penny stocks are, and some of the best trading platforms available, you may be wondering how you actually go about day trading penny stocks.
The process is simple enough, so continue reading my guide to find out how to invest in penny stocks.
1. Decide which broker you want to use
First off, you need to decide which penny stock trading brokers you want to open a trading account with.
Using the information above in my guide, you ideally want to compare the different trading platforms and figure out which best suits your needs.
For example, when beginners buy penny stocks, they may want to consider trading platforms that offers in-depth research, analysis and trading tools.
Or, if you were planning on trading large volumes of shares, you may want to think about opening an account with a penny stock broker with lower trading fees.
2. Set up an account with your broker
Now that you’ve decided which penny stock broker you want to use, the next step is opening an account with that broker.
This process is simple enough – usually you will be required to input your information, and potentially upload any relevant financial documents the penny stock broker needs to confirm your identity.
It’s worth keeping in mind that if you’re based in the United Kingdom and want to start trading penny stocks from the US, you may have to complete a W8 BEN form.
3. Make a deposit to your brokerage account
Now you’re ready to make a deposit to your penny stock broker account.
Again, this is a simple enough process. All you need to do is input the value of money you wish to deposit and make sure it enters your account, typically using a credit or debit card.
Be mindful of inflation
One thing you should be wary of is how much money you deposit into your broker account.
You ideally only want to deposit the amount of money you are planning on investing in penny stocks.
When you deposit money into an investment account, it’s unlikely that you will earn interest on any uninvested money. And, with inflation currently so high, there’s a chance your savings’ purchasing power will be eroded in real terms.
You should also only deposit and invest what you can afford. If you end up losing money, you may end up unable to pay your bills or afford your current lifestyle.
4. Decide how you want to invest in penny stocks
Next, you’ll need to figure out how you want to invest in penny stocks in the first place.
If you’re still a beginner to penny stock trading, you may want to consider either trading shares traditionally, or gaining exposure to them through a fund.
Of course, you can always try your hand at penny stock CFDs or spread betting, but you should be aware of the complexity of these financial instruments – more than half of retail investor accounts lose money trading derivatives.
5. Make the investment
When all of the above steps have been followed, you’re finally ready to start trading on penny stock markets.
Simply search for the company or fund you wish to invest in, decide how many shares you’re going to buy, and then make the purchase.
Or, if you wish to trade derivatives, all you need to do is search for the specific instrument and open a position.
The work doesn’t stop when you buy penny stocks though – you need to ensure you keep an eye on any price fluctuations with your penny stocks.
You may want to set up a stop-loss limit on your position to ensure that, if prices drop too much while you aren’t monitoring your order, you won’t lose too much money.
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*Capital at risk
As someone deeply immersed in the world of financial markets, particularly in the realm of stocks and trading, it's evident that the topic of penny stocks is crucial for investors seeking high-risk, high-reward opportunities. My expertise stems from years of hands-on experience in analyzing market trends, studying various investment strategies, and staying abreast of financial news.
Now, let's delve into the concepts outlined in the article about penny stocks:
1. Penny Stocks Definition:
- Definition: Penny stocks are companies with shares trading at a low price, often below £1 in the UK or $5 in the US. These stocks may not perform poorly solely due to their low share prices. However, some issues may arise, such as decreased liquidity in smaller, less frequently traded companies.
2. Liquidity and Bid Spreads:
- Liquidity: The liquidity of a penny stock is crucial for investors. Lower liquidity can result in wider bid spreads, which is the difference between the asking and bidding prices. This liquidity factor is especially significant for UK penny stocks traded on the alternate investment market (AIM) of the London Stock Exchange.
3. Risks Associated with Penny Stock Trading:
- High-Risk Nature: Penny stocks are generally considered high-risk investments due to lower liquidity and higher volatility. Investors may face the potential risk of losing their entire investment due to significant stock price swings.
- Limited Information: Compared to well-established companies, penny stock companies often provide less available information, making it challenging to gauge their performance and potential market movements.
4. Different Ways to Invest in Penny Stocks:
- Individual Shares: Purchasing shares individually through a broker is a common method. Investors can sell shares later for a profit or hold onto them, especially if the company offers dividends.
- Funds: Investing in penny stocks through funds offers diversification. Fund managers oversee the pooled investment, spreading risk across various companies.
- Derivatives Trading: Involves methods like spread betting and Contracts for Difference (CFDs). These derivatives can be riskier, and caution is advised.
5. Spread Betting and CFDs:
- Spread Betting: Involves "betting" on the movement of a company's share price, with potential payouts based on the direction and amount of movement.
- CFDs: Contracts for Difference entail receiving the price difference from the opening to closing positions, with an initial margin payment.
6. Best Practices and Considerations:
- Stop-Loss Orders: Traders often use stop-loss orders to limit potential losses by automatically selling shares if a predetermined value is reached.
- Research and Information: Due diligence is crucial, considering the limited information available for many penny stock companies.
- Diversification and Risk Management: Investors are encouraged to diversify their portfolio and manage risks, especially in the volatile world of penny stocks.
7. How to Start Investing in Penny Stocks:
- Choosing a Broker: Selecting a reliable penny stock trading broker based on individual needs, such as research tools or lower trading fees.
- Account Setup: Opening an account with the chosen broker, which typically involves providing personal information and potentially financial documents.
- Deposit and Investment: Depositing the intended investment amount into the broker account and deciding on the preferred method of investing in penny stocks.
In conclusion, investing in penny stocks requires careful consideration of risks, thorough research, and an understanding of various investment methods. Whether opting for individual shares, funds, or derivatives, investors should tailor their approach based on their goals and experience levels.
