Because penny stocks sell at low prices, they create an opportunity for a significant upside in terms of share appreciation. However, they are equally risky because of the higher chances of failure and losses. Penny stocks are considered as high-risk investments because:
They lack liquidity
Liquidity is the ease with which a company’s assist or security can be converted into ready cash without significantly affecting its market value. Liquidity, therefore, allows you as the stocks trader to enter and or exit a stock at the desired price.
Because penny stocks are traded infrequently wit few buyers, an investor is likely to make losses because they may not be able to sell their stock once it is acquired since there are not many willing buyers.
Going by the laws of demand and supply, the investor is therefore forced to lower their selling price to make the stock appealing to the few willing buyers. This predicament means the investors are most likely forced to take on significant losses as a result.
They are highly speculative
Penny stocks lack liquidity, with minimal to no wide bid-ask spreads or price quotes and the small company sizes with limited resources mean that investors who take on trading penny stocks are more likely to lose large amounts or even all of their investment capital.
The lack of minimum standards
Minimum standards in the stock market are an essential safety cushion for investors and some companies. Companies with Blue-Chip stocks are expected to fulfill certain minimum standard requirements to remain on the exchange market.
Stocks traded on the over the counter bulletin boards like penny stocks, for example, are not obligated to fulfill these minimum requirements. These small companies once incapable of maintaining listing position in a given major exchange, they are free to move to another relatively smaller over the counter Listing exchanges.
No reliable history or track record
Penny stocks are associated with small companies, which have been recently or newly formed and hence lack a history or track record to go by. This lack of track record makes it significantly difficult to accurately evaluate their stock’s potential.
Additionally, these companies are also more vulnerable to bankruptcy and total collapse
More prone to Fraud
The low liquidity associated with penny stocks creates an opportunity for fraudulent activity. Some traders exploit these weaknesses to manipulate stock prices. The most common form of this fraud is the pump and dump scheme where some traders lure investors into acquiring stock and then they later dump their shares making the stock prices plummet.