Why Are Penny Stocks So Volatile?


Investment in penny stocks is often considered gambling. It is like an adrenaline rush where the outcomes are unknown, and the stakes are high, even with a low investment. This peculiarity of penny stocks often leaves the investor hesitant about taking the plunge – in penny stocks.

Penny stocks are so volatile because they are easily influenced by external sources, price manipulation, and pump and dump schemes. Since the companies introducing these stocks are mostly on the verge of collapse, investors rarely hold penny stocks for an extended period.

This article aims to explain why people invest in penny stocks, knowing their volatile position. It covers the myths about high potential while explaining the factors that drive the price of penny stocks. The risks involved in the investment are also explained in great detail. 

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Why Do People Invest in Penny Stocks?

Penny stocks are typical ‘a low investment, high return’ fantasy that attracts individuals new to the spectrum of stock investments. Trading for these stocks starts at $1 and consistently remains low for all the companies involved in the market.

The companies floating penny stocks tend to have a financially challenged background. The unproven tales of such companies indicate their unknown outcomes. Investing in penny stocks is like hoping for a stroke of luck and pining for a jackpot from a crumpled lottery ticket.

Penny stocks are sold like a crumpet of hope that an obscure stock will suddenly hit the top and get exponentially high returns. After all, penny stocks don’t enjoy blue-chip’s glory, which means a lack of liquidity and prospects in the future. It is a game of subjectivity, mostly since the stocks’ volatility is reason enough to avoid them like the plague.

Penny Stocks and the Myth of Medusa

There are many myths about stock investments. The typical story involves purchasing stocks at their lowest price and selling them when the movement is positive. Another variation of this myth is found in discussions on penny stocks.

It is often assumed that an investment in a mysterious company could turn the page from rags to riches. The manipulative ideas of significant returns from minuscule investments leave the inexperienced investors tempted to try something risky.

While there have been a few success stories for penny stocks, most people have experienced complete loss. Undoubtedly, the risks involved in purchasing stocks from a new company remain similar regardless of the context of penny stocks and regular stocks, but the bubble of high hopes must be pricked.

The highly volatile nature of these stocks leaves them wild and wandering. The dubious origins of companies and unregistered information about the finances are clear indicators of the situation, yet the optimism of a naïve investor conceals all the red flags!

The stocks of IBM and Apple sell for high prices due to their institutional sponsorship, which is not vulnerable to pump-and-dump scams. The fraudulent marketing of penny stocks leaves the investor thinking that they could be touched by Medusa and would turn to gold as soon as the initial investment is made!

What Drives the Prices of Penny Stocks?

Most investors believe that low-priced shares’ price movement depends on acquisitions, new customers, and corporate earnings. These factors are significant for the situation, but when it comes to penny stocks, the price manipulation falls in the hands of other factors.

Technical imbalances in trade are often flagged as the most critical player for penny stock companies. It is observed that there are few buyers and fewer sellers for low priced stocks at any specific instance. The low consistency of trading results in technical imbalances that affect the price of the stocks.

Typically investors choose stable blue-chips to receive high returns for a couple of years. When a blue-chip company suffers a loss or has lower returns, the investor has immediately gravitated towards something risky with better potential for high returns. 

This desire to get better returns leads investors to risky assets like penny stocks and micro-caps. While they look for stable returns that resemble the blue-chip profits, the money continues to flow towards low-priced stocks that escalate their price. Any unexpected raise can drive up the costs immediately.

The media is another factor that leads to quick price movements in penny stocks. When insight about high returns on CBD, robotics, or biotech is circulated on news publications, the naïve investor is directly drawn to the industry’s lowest-priced stocks. 

While the investor continues to dream of returns that resemble Amazon or Apple, they forget to realize that the stock market is secretive and spontaneous when it comes to high potential opportunities. By the time the news about the potential of a marijuana company broke out, the opportunity had already passed.

What Are the Risks Involved?

Risks are involved in any stock investment, but their existence grows manifold when penny stocks are at stake. Companies with transparent backgrounds and finances get listed on the stock exchange, the stocks from lower-ranked companies get traded at a low price, mostly through OTC trading.

These stocks’ speculative nature keeps the experienced investors at bay while the inexperienced investors dive head-first into its turbulent waters. The low capitalization of these stocks adds fuel to the fire of risks involved in achieving significant profits on small investments. Those invested in penny stocks tend to forget the adage for stock investments: ‘You get what you pay for!’

The short-lived media-influenced frenzy episodes in these stocks’ price movements prove to be a lousy investment time and time again. Since sufficient investors have fallen prey to manipulative brokers’ schemes about penny stocks, here are a few risks that you should consider about penny stocks irrespective of the fantasy they create!

High Manipulation

Penny stocks don’t necessarily attract high bidders, which is why the brokers are forced to come up with convincing lies that would not get detected by an unsuspecting new investor. Any minimal investment in these stocks can boost its price, which is often used to bilk money. If you invest $100 for $5 stocks and the market rises by 200%, the manipulative broker wins a fair share of investments for stock worth in scraps!

Illiquidity

The volatile penny stocks don’t have enough buyers and sellers at a given time. Since the low-priced stocks are exchanged so thinly, they lose the charm of liquidity that attracts an investor to stocks in the first place. While stable stocks like the celebrated blue-chips are easy to sell at high returns, the penny stocks continue to paint a gloomy picture due to their low volume.

Absolute Loss

When you decide to invest in penny stocks, you must be prepared to lose it all. These stocks do not have the grounding afforded to indexes. The low interest and trading opportunities leave a large room for loss and recovery in some fortunate cases. These stocks do not move according to the market trends and hence leave the capital at enormous risks.

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Conclusion

Penny stocks are a risky investment. The only way one can withstand these stocks’ volatile pricing is to keep an open eye on your sources of information. Whether it’s an email claiming to get you a few grand through small investments or boiler room scams, any of these manipulative messaging tactics can get to you and distort your investment plans. 

The rule of thumb is to avoid penny stocks that you’re intuitively doubtful about and try to do your homework before signing up for anything that your pocket would mind at a later stage. Invest only what you are willing to lose.

BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!

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    Navdeep Singh

    Navdeep has been an avid trader/investor for the last 10 years and loves to share what he has learned about trading and investments here on TradeVeda. When not managing his personal portfolio or writing for TradeVeda, Navdeep loves to go outdoors on long hikes.

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