Many beginners to stocks and shares investing get all excited when they find out about penny stocks / penny shares.
They see them trading at a low price and think that this makes them cheap to buy so they pile in, spending what little money they have on them.
All too often though, it is not long before they regret buying the shares when the company goes bust or the share price falls dramatically.
Not knowing what they have done wrong, they lose heart and conclude that share investing is not for them and is too risky.
If you are tempted to buy penny stocks and shares, then keep reading to find out more about them so that you don’t get caught out.
What Are Penny Stocks And Shares?
Penny stocks are company shares that are trading on non-UK stock markets at a price below $1.
Penny shares are company shares trading on UK stock markets at a price below £1.
For the rest of this article, I am going to use the collective term penny stocks because they have exactly the same characteristics whatever stock market you are trading on.
Penny Stocks Are Not Necessarily Cheap
One of the biggest mistakes that beginners to share investing make is to assume that penny stocks are cheap because they can be bought for less than $1.
Similarly, they believe that a share trading at over $500 per share, like Apple for example, is expensive.
Unfortunately, neither of these is true!
Whether a company’s shares are cheap or expensive depends on how much they can be bought or sold for compared to what they are actually worth.
In other words, if a share is trading below its valuation then it can be regarded as being cheap and vice versa.
More information on how to value company shares can be found here.
Penny Stocks Are Expensive To Buy And Sell
Every share that you buy and sell has a price spread.
The price shown on web sites and share price graphs is called the mid-price which, not surprisingly is usually mid way between the buying price and the selling price.
This may come as a surprise to you but every share quoted on a stock exchange has a buying price and a selling price which are different.
The price that you buy at is always higher than the price you sell at.
The difference between the two prices is called the spread.
The reason why penny stocks are relatively expensive to buy and sell is because the spread is large compared to the price of the shares.
Examples Of Share Price Spread
As I am writing this article, GlaxoSmithKline (GSK) shares can be bought on the UK FTSE stock market for 1435.5p, sold for 1435p and thus have a mid-price of 1435.25p.
Therefore the spread is 1435.5 – 1435 = 0.5p.
As a percentage of the mid-price, this is o.5 / 1435.25 = 0.035%.
Now let us contrast this with a penny stock.
JJB Sports (JJB) is currently trading at a mid-price of 10.875p but it can be bought for 11.5p and sold for 10.75p.
Thus it has a spread of 11.5 – 10.75 = 0.75p.
As a percentage of the mid-price, this is a spread of 0.75 / 10.875 = 6.897%.
Notice that this spread is 197 times that of GSK!
In this comparison, I have just chosen two stocks quickly so this is not going to be the result for every two stocks you compare.
That said, you will always find that the spread on penny stocks is much greater than that for large blue chip stocks like GSK.
Why Is The Spread Larger For Penny Stocks?
The spread reflects how often the stocks are traded and thus how much the share price could move between the stock market trader buying them from a seller and passing them on to a buyer.
The traders in the market are constantly buying and selling shares to and from their customers when the markets are open.
Large blue chips like GSK trade in much higher volumes and more frequently than do small cap shares like JJB Sports.
Hence it is easier and quicker for a market trader to move blue chips shares on and they spend less time holding them looking for a buyer than they do for small cap shares.
This lower liquidity and greater volatility for small cap shares increases the risk of the market trader losing money and hence why they need to afford a larger spread between their buying and selling prices.
The spread is therefore a source of profit for the trader in the stock market.
Because you are ultimately, via your broker, buying and selling your shares from and to the stock market traders, their source of profit is a cost for you, the investor.
Notice that the shares that you buy need to rise in price by the spread before you can sell them again at a profit.
So if we conveniently ignore the brokers commission fee (which we can’t in reality but it makes the mathematics easier to understand here) and the stamp duty if we are trading in the UK, then our JJB Sports shares would need to rise in price by 0.75p (the spread) before we could sell them again at the same price as we bought them.
For JJB, this is currently a rise of circa 7%.
Likewise, if we bought them at 11.5p and the share price fell by 0.25p before we sold them, we would likely be selling them at a lower price of 10.75 – 0.25 = 10.5p.
In which case, we would have lost 1p on every share which is 1 / 11.5 = 8.7% when the share mid-price of the share had only fallen from 10.875p to 10.625 = 0.25p which is 0.25 / 10.875 = 2.3%.
The big lesson here is that small cap penny stocks can eat into your profits very quickly and can increase any losses you have quite dramatically.
Despite what I have said about penny stocks in this article, they can be very exciting for a host of other reasons, which I have not mentioned here.
But being “cheap” is not one of those exciting reasons and is certainly not a reason to buy them unless they really are cheap when measured using proper share valuation methods like I mention in my other articles like this one.
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