How to Respond to Market and Company Risk for Penny Stocks - dummies

How to Respond to Market and Company Risk for Penny Stocks

By Peter Leeds

The two primary types of risk for your penny stock investments are market specific risks and company-specific risks, also called systemic risk and nonsystemic risk. Market specific risk, or systemic risk, relates to factors that can bring the overall stock market, sector, or industry down to lower prices even though there may be nothing inherently wrong with each of the underlying stocks.

If the stock market crashes, that is risk related to the system, or systemic risk. If a single sector or specific industry group is likely to sell off, that is also systemic risk. When shares of many companies drop in price in unison, investors say that they are “trading in sympathy.

Company-specific, or nonsystemic, risk relates to a company directly. If a penny stock you’re holding gets hit with a huge lawsuit, the downside risk is focused only on that company. If the entire management team of a certain low-priced investment you hold suddenly vacates their positions, the probable decline in the share prices is risk you face that is specific to that penny stock rather than its industry or sector.

Knowing which type of risk you are experiencing, or may experience, will go a long way in providing clarity for your trading moves. You may not need to worry if your shares are lower along with the overall market. However, if a specific penny stock you own is trading lower while the industry and overall market are on the rise, you need to know exactly why.

How to react to nonsystemic risk for penny stocks

When a share suffers a downside move, you need to recognize whether this weakness is based on an issue with the company itself or is due to a downward slide across the entire industry or market. Compare the company’s trading direction against the overall industry. Your reaction should be different depending on whether or not the negative move is an issue with the specific company.

Take nonsystemic risk events very seriously. Depending on the severity of the issue, it may be time to sell your shares, especially if you expect things to get even worse or if there will be a very long time before the company will be able to resolve the concern.

If a penny stock is hit with a significant lawsuit, loses one of its few clients, or has a new billion-dollar competitor enter its space, these company-specific events will change the company’s outlook and weigh on shares for an extended period. If a stock you’re holding runs into major detrimental events, you may want to consider selling your shares.

Keep in mind that penny stocks can sometimes do well despite major company-specific risk events. Every penny stock and situation is different, so don’t run for the exits each time a negative event occurs.

Assess each situation and decide every trade on a case-by-case basis. Give the penny stock a fundamental and technical review to decide what action to take.

Sometimes you will want to hold the course, other times you should dump your shares as fast as your computer can send in the trade. The better you get at knowing how to react, the greater success you will have with your penny stock trading.

How to react to systemic risk for penny stocks

Failure to understand the difference between market risk and company risk is a major source of trading mistakes for penny stock investors. In fact, when all stocks trade down in sympathy to overall market weakness, the shareholders who panic and sell individual stocks very often regret their decision within days or weeks.

Don’t react to market risk in the same way as company-specific risk. Weakness that affects entire segments of the stock market (systemic risk) isn’t necessarily indicative of problems with operations of specific companies that just happen to be caught up in the downward current. Making a decision to sell based on price weakness that is completely unrelated to that specific penny stock is often a mistake.

If a news story about deadly bacteria in some of fictitious FFFF’s vegetables spooks investors, they may sell off all food and farming stocks. As the problem is addressed within a couple days, is related only to FFFF corporation, or even turns out to be false altogether, those same food and farming stock shares will return to former levels.

The investors who lose are the ones who sold their stock in the companies (other than FFFF) in reaction to the nonsystemic event. They cashed out at lower prices and missed out as those same stocks returned to former levels.

Take advantage of market panics

Market panics and reactions to systemic risk are a great way to pick up penny stocks at discount prices. When an event pushes an entire sector down, but specific penny stocks you’ve been watching remain strong — they’re still growing their market share, increasing their revenues, and shrinking their loss every quarter — it’s a great time to pick up shares at discounted prices.

Manage long-term systemic risk

Some market risk events result in long and significant weakness in entire industry groups, and you shouldn’t expect that shares will recover any time soon.

Although systemic risk usually isn’t a reason to sell, there are times when selling is appropriate. For example, consider a nuclear meltdown that is front and center in the media, spooking investors, and driving shares of uranium mining stocks down sharply. All companies related to nuclear power will take a hit, and that systemic risk may remain for months or years; the smart move may be to sell your shares.