Have you ever visited a flea market when on holiday at a resort destination? You will have noticed that there is a huge variety of low price souvenirs and trinkets on offer, but you do usually need to check these to ensure that they are of good quality. Buying penny stocks is something like shopping at the stock market’s own little flea market. You get low share prices, but you need careful evaluation.

Penny stocks come from companies with essentially 3 criteria:

  • Low market capitalization, usually less than Rs 50 crore
  • A low share price, typically Rs 10 or less.
  • A small volume of shares on the market

While the low price may seem attractive, if you are considering buying penny stocks, it is imperative that you have a thorough understanding of the risks involved, and know how to evaluate their potential worth.

Why do investors buy penny stocks?

The main attraction of penny stocks is low capital requirement. Investors are able to get stock market exposure at a very low price. Some penny stocks trade for even less than Re 1 per share.

Eg. Maharashtra Corp traded at Rs 0.50 on 8 July, 2021. Gold Line Int. opened the day at Rs 0.27 per share.

Another bone of contention in favor of penny stocks is the potential growth prospect they present given the catch-up space they have with large-cap stocks, or even small-cap stocks.

What are the risks involved in buying penny stocks?

Penny stocks are high risk investments because:

Financials and other fundamentals – Because penny stocks come from companies that are not very sizable, investors have a challenging time getting hold of trustworthy data to conduct fundamental analysis of these companies.

Compliance to norms – Another potential risk arising out of small company size is that they might (due to oversight or simply lack of expertise) find themselves embroiled in regulatory issues. Investors stand to lose out should such a stock be suspended from trading by the regulator, that is SEBI.

Illiquidity risk – Low market cap directly corresponds to a low number of shares being traded on the stock market. There is a high chance that there may be no interest in these stocks and they may become illiquid and remain so for extended durations until investor interest revives.

Manipulation of stock price – Low volumes is a ripe situation for manipulation. For example, the price of the penny stock might be set up to soar by purposefully buying a large volume of the shares on the market, or the price can be made to tumble drastically by dumping stock in large volumes. It is possible to achieve large enough volumes to manipulate the stock price because there are fewer shares on the market.

How to pick penny stocks

Investors should pick penny stocks after conducting their own fundamental analysis and thorough technical analysis.

Evaluate using technical analysis

You must wrap your head around technical charts and indicators in order to make observations linked to the share price of the penny stock. You need to watch for 2 things.

Overall patterns:

You should be able to understand the patterns of dips and spikes in the share price. Train your eye to observe patterns that appear in the stock graph. For example –

  • You will notice that while the price fluctuates continuously, there might be a particular price band between which the price fluctuates – at least during a certain period.
  • You might be able to notice that the share price of a penny stock is on an uptrend, or alternatively on a downtrend.

You need to observe (at a minimum) a 3-month to 6-month price chart before you are ready to invest in a penny stock. Investors typically play it safe and try to buy when the price is closer to the 6-month low and sell when the price is at a 3-month to 6-month high.

You can learn all about technical analysis right here on the Angel Broking investor education resource.

Volume

After overall stock price patterns, the second factor to consider when evaluating penny stocks is volume. Volume takes on absolute significance when trading penny stocks. Observe how volume is affecting the price volatility.

Secondly, consider the volume of stock that you will purchase based on the average daily and monthly trading volume. You do not want to end up with 1000 shares if only 65 are bring traded per month.

Conduct independent research

Over and above evaluation of penny stocks using technical analysis, you should do what you can to track down the company’s historical financial data. Investors should verify the authenticity of data received in these small companies because there have been cases of audited results being doctored. Avoid being swayed by any “guaranteed tip”.

The best performing penny stocks can be identified using technical analysis – if the numbers display lacking potential, most investors would prefer to steer clear.

Conclusion

When buying penny stocks, investors need to avoid emotional trading at all costs. It is easy to be swayed by greed with irresistible buy in prices, but investment should always be about calculated risk and investment goals. Investors should consider their risk appetite and the risk-reward ratio of any stock market investment, but all the more so for penny stocks because of their high risk nature.