Market Strategy

Be careful with penny stocks…

Rajalakshmi Sivam | Updated on February 19, 2011


“When in the market, it is hard to resist the temptation to buy momentum stocks, who worries about fundamentals really?” asked a trader friend. He may be right, but sometimes it can turn to be a costly mistake! In a rage to catch momentum stocks, you may blow up that little you made in the market after years of calculated moves. Penny stocks that show violent intraday movements are risky counters and not a novice trader's sport. Though these stocks make spectacular gains in a bull market, a turn of the tide may see them topple down with a ‘magnifier' effect.

This week, we take a look at investing in ‘penny' stocks and how these can make and mar a portfolio.

When ‘all is well'

In good times, penny stocks will be at the fore of the rally. In March 2009, when the market started to recover post the recession blues, penny stocks saw some swift up moves. Stocks such as Country Club, Lok Housing, Megasoft and Sujana Towers gave a return of 80-160 per cent in a month's time when the Sensex had the credit of rising only 30-35 per cent in the same period. But, keep in mind that these stocks are the first to be whipped when the market crashes. Penny stocks suffer high volatility and exiting them at the right point is next to impossible.

Circuit filters (that arrest price movement in the stock) that are normally at 5 per cent in these counters hold violent price moves momentarily. But there have been many instances when in the opening hour itself these stocks hit the lower circuit and they continue doing so for many consecutive days as investors look on helplessly.

Risks of investing

Even on a normal market day, you can find a bunch of stocks that had hit the upper circuit. It is hard to know what moves these counters (sidey game of price-rigging by operators?) but they are successful in catching traders' fancy and come to limelight in a day's time. If you observe, these stocks will generally be penny stock counters — where the share price is below Rs 10. The ‘T' (scrips that are settled on trade-to-trade basis), ‘S' (companies that are from the small and medium enterprises group) and ‘Z' (scrips that have not complied with some of the listing norms) group scrips of the BSE universe appear here most times. There are many risks in investing in these counters:

The wave that took these stocks up can reverse any time and when that happens, volumes fade and liquidity dries up. You may not find buyers in the counter all of a sudden. My friend was locked with open position in one such stock — Birla Power, a week back the stock didn't show buyers at all and then before she could bat an eyelid, it had closed at lower circuit. As many of the penny stocks don't go up rationally, they see crazy price corrections too — the same stock that hit upper circuit a few days back may close at lower circuits for four-five trading sessions continuously. A good example here is that of the stock of Cals Refineries — when this stock will freeze at the upper circuit and when at the lower, is a tough guess even for an ardent trader.

If you don't exit with profit and you end holding the stock, the consequences can be even worse. Many of these penny stocks don't have adequate information on them in the public domain and their standards of corporate governance are questionable. Negative developments if any can reduce the stock to a fraction of your buy price!!

What you can do

Penny stocks are extremely risky investment bets and only those investors with fairly large portfolios should divert a small fraction of their holdings in these stocks. Investors with lower risk appetite and those with insufficient time to monitor their portfolios should stay away since exiting at the apt juncture is the key to making money on these counters.

Published on February 19, 2011

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