Every retail investor loves penny stocks because of their potential to turn a small average investor into a wealthy individual. Unlike bigger companies which are generally stable, penny stocks fluctuate a lot & can switch from lower circuit to upper circuit within a matter of minutes! This extreme volatility & unpredictability can make these stocks less of an investment & more of a gamble. But why do penny stocks fluctuate so much?
Any stock which trades under a price of Rs. 10 per share is generally considered to be a penny stock. Often, penny stocks are very small & unknown companies which are in the starting phase of their business life or they are bigger companies which have fallen from grace due to a failing business model. The price of a penny stock moves exactly the same way as any other stock – supply and demand. The stock price moves up when there are more buyers for the stock who are willing to buy at a higher price & the stock moves down when there are more sellers for the stock who are willing to sell at a lower price. To learn more about how stock prices fluctuate, visit this article!
But there is something special about a penny stock which makes them extremely volatile & causes them to fluctuate so much. The major reason for the fluctuation is the low market capitalization of the penny stocks. Market capitalization (also known as market cap) refers to the total value of all the stocks of the company. Let’s suppose a company has a total of 10,000 stocks each of which is trading at a price of Rs. 10, then the market cap of this company will be Rs. 1 Lakh. Penny stocks are generally very small companies or big companies which have failed in the past & this causes the company to have a much smaller market cap as compared to bigger established companies. This low market allows the stock price to fluctuate a lot. Let’s consider two scenarios.
Why are large caps companies stable?
Let’s suppose a big fund wants to buy all the TCS stock which is being traded in the market. The average volume of the TCS stock (in Jan, 2022) is 25 Lakhs. Each stock costs almost Rs. 4,000 at the time of writing. So, in order to buy all the available TCS stock, the big fund will require a capital of Rs. 4000 X 25 Lakhs which is Rs. 1000 Crore. This is not even considering the fact that when the fund starts to buy stock, it will push up the price of the remaining stocks even higher. To buy every single TCS stock on a trading day can require over Rs. 1000 Crores which is a monumental amount of capital! This is the reason why such stocks with high market cap tend to remain stable and immune to manipulation.
Why are penny stocks unstable?
On the other hand, let’s suppose a big fund wants to buy all the stocks available in the market for a penny stock called Radaan Mediaworks. This is a penny stock which is priced at Rs. 1.85 at the time of writing. The average volume of the Radaan Mediaworks stock (in Jan, 2022) is 15000. So, in order to buy all the available Radaan Mediaworks stock on a trading day, the big fund will require a capital of Rs. 1.85 X 15000 which is only Rs. 27,750. This is such a small amount of capital that even an average investor can buy this stock & send the price skyrocketing! This is the exact reason why many penny stocks can go back & forth between upper circuit & lower circuits within a matter of minutes because anyone can manipulate these stocks without needing a big capital.
Should retailers invest or trade in penny stocks?
Investment in penny stocks is highly dependent on luck rather than skills because they can be easily manipulated by big funds. These kinds of stocks should be a complete avoid for long term investors because of the high risk involved. Traders should also remain cautious of these stocks because such stocks sometimes do not provide a clear exit. A trader looks to enter & exit a stock at a specific price to make a profit on the trade. Getting stuck in a trade because the stock is constantly stuck in a lower circuit can cause traders to lose their precious capital & time. A high level of luck is involved when dealing with such stocks which makes them unsuitable for trading. However, it is up to the reader to decide whether to trade or invest in penny stocks!
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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