Blog : 5 Differences - Penny Stocks vs. Blue Chips

by Peter Leeds on March 30th, 2015

There are many differences between penny stocks and other types of investments, which means that your investment approach towards penny stocks must be adapted accordingly.

Large Price Spread - The difference between the bid and the ask price is generally greater for small cap stocks. This is due to 2 factors; fewer parties are involved in the trading of penny stock shares, and appropriate valuations are much more difficult to estimate for penny stock companies.

The spread between bid and ask prices for small cap stocks can often be greater than 10%, so it is very important to use a LIMIT order rather than a MARKET order, so as to ensure the trading price of the shares you buy or sell.

Volatility - Penny stocks are often very volatile and can make large percentage moves in short time frames. This means that investors should keep a watchful eye on their investments, rather than buying and holding for the long term.

While there are many penny stocks available which may be long term investments, they still need to be monitored very closely due to their volatility.

Conventional Rules Don't Always Apply - Forces driving penny stocks are very different than those affecting the share prices of other types of investments. For example, speculation, promotional efforts, seasonality, and potential are a few criteria which should be examined in greater depth with penny stocks than other investments.

As well, depending on the type of company, patents and technological innovations, success of surrounding exploration claims, past management successes, and corporate alliances can also play a major role in the direction of the share price.

While other criteria do apply, such as technical indicators, fundamental analysis, insider trading, and institutional sponsorship, they impact the underlying stock differently depending if it is a small cap company or a large cap company.

Takeover and Acquisition Targets - The smaller relative size of many penny stock companies makes them more likely to be taken over by larger companies in the same industry.

As well, many smaller companies have the rights to important exploration lands, technology patents, or strategic market share which they don't have the resources to effectively exploit, meaning that larger corporations can move in and benefit where the small cap company was unable to.

When a company gets taken over it is usually to the benefit of the shareholders, as they often get a price premium for their holdings.

Investor Expectations - The reasons for investing in penny stocks generally involves the hope of large, significant profit. The average investor will hold their shares in a penny stock company for shorter time periods than they would for a blue chip corporation, and will hold out for significant profits before selling their shares.

This is important to consider when gaining an understanding of investor sentiment towards a particular company, and extrapolating share price movements from that understanding.

Investor expectations are also different as they relate to company operations. It is generally more acceptable for a small cap company to be losing money, over-spending on research and development, or growing very rapidly.

It is less than acceptable from an investor's point of view for a penny stock company to be undergoing negative or nil growth, to be paying dividends, or to be diversifying among non-related industries.  We discuss all of that here, where we reveal our research methods.

The same does not apply, however, when dealing with large cap corporations.  Therefore, there are distinct differences in expectations in penny stocks, when compared to investors in larger corporations.

Having an understanding of what makes penny stock investing unique will go a long way to knowing what to expect from the behavior of traders in the shares, and by extension knowing when prices are undervalued, and when to take a profit in penny stocks.