In-depth Analysis

Stock Trading – Blue chips vs Penny stocks

 

If you’re planning on becoming a successful stock trader, you’ll want to understand the key differences between blue chip stocks and penny stocks. Doing so will allow you to make well-informed and therefore better trading and investment decisions. You’ll be able to manage risk more effectively and optimize your chances of making significant profits by choosing the right stocks for your trading style.

The two types of stocks we’ll introduce to you in this article are very different in terms of risk vs reward, and the means for trading them are generally different too. So let’s take a look at the major distinctions, so then you’ll be able to decide for yourself what suits your portfolio and long term investment plan, and how you might also be able to profit from short term market movements.

Blue chip stocks

If you’re a bit of a gambler and you know your way around a poker table, you’ll be aware that the blue chips are generally the ones that carry the most value. It’s often the same in the stock market too.

 

Although there isn’t any one definition of what constitutes a blue chip company – and it can be a little open to interpretation – most investors and traders recognise them as the cream of the crop in the stock market. They’re typically reliable, well established, and have a strong management team. They’re financially stable with decent cash flow and are often considered as defensible stocks, which means that they usually perform relatively well regardless of the wider macroeconomic environment.

 

These are generally leaders in their various industries, reputable names you would recognise, or companies with products you tend to use every day. Downturns don’t bother them much, and generally they’ve survived more than a few already. Blue chip stocks generally also pay out some pretty decent income in the form of dividends too.

 

A list of some of the bigger blue chip stocks in the US are brands such as Visa, American Express, Home Depot, Intel, Apple, Microsoft, and many more.

 

The number of companies classified as ‘blue chip’ depends on the set of criteria used to define them. Some people say they’re limited to the 30 stocks that make up the Dow Jones Index. Some regard market capitalisation of over $200 billion as a key metric. Others look at dividend growth as a determining factor.

 

Pros of blue chip stocks

 

  • They’re typically not overly volatile
  • They’re often traded on major exchanges, which means that you can easily find reliable, public, and transparent information and data about them
  • They often provide consistent returns
  • There’s usually less risk of heavy losses during downturns
  • There’s usually income potential in the form of dividend payments

 

Cons of blue chip stocks

 

  • They can be expensive or even out of reach for some investors
  • They’re generally not suitable for substantial and/or quick profits
  • They can have low rates of growth
  • Their dividend yields can turn out to be quite low sometimes

Penny stocks

Penny stocks, on the other hand, are from companies that might have recently listed their companies through an initial public offering (IPO) and are potentially just starting out. They are often less-known companies or very small companies. The value of their shares is often minimal, maybe $5 or less, and they’re an up-and-comer in their industry that you might not have heard of.

 

These types of companies won’t generally have a proven track-record of making a profit or surviving downturns yet. Investors also shouldn’t expect to earn dividends in the early days from these companies.

 

Trading in penny stocks attracts the type of investors that have hopes of getting flat-out rich on the next big thing. They dream that suddenly these companies will become notable and grow from the lows of $5 or less to hundreds of dollars or more. After all, most big caps and blue chips started as penny stocks… it can happen, but more frequently, the opposite happens too.

 

Penny stocks can be found on some major exchanges, but more often in the US you’ll find them on the OTC Bulletin Board or the OTC Markets Group.

 

Pros of penny stocks

 

  • There’s potential for significant profits if you’re investing in the right companies
  • It can be exciting to watch them grow
  • Small investors can participate without needing much capital
  • Value can grow quickly

 

Cons of penny stocks

 

  • Liquidity tends to be on the low side
  • Volatility is often high
  • Slippage is a real concern
  • They can be prone to scams
  • They can be very risky

Final word – How to choose between the two types of stocks

Research is a big part of making a successful living by trading in the stock market. Having the ability to read and understand trends, macroeconomic conditions, financial statements and other reports are important when deciding what investments to choose. It is also important to take into consideration your risk appetite, your capital, your strategy and your objectives.

 

There is no right or wrong selection when it comes to your personal choices here. What matters most is that you know your own limits and understand how the decisions you make will impact your trading plan and risk profile.

 

It may be best to have a diversified strategy that involves the ownership of a collection of both penny and blue chip stocks.

 

Some investors like to adopt the ‘core and satellite’ approach with their portfolio, meaning they have a base of reputable and ‘safe’ investments which include blue chip stocks as their “core”. Then they’ll also keep a few speculative penny stocks on the side as part of their “satellite” category. In this strategy, the trader is investing money they can afford to lose on these perceptually riskier types of positions, so if they do well, great! If not, it’s no big deal.​

 

There are various options at your disposal for trading in both penny and/or blue chip stock.

 

In addition to having direct ownership and purchasing the stocks, you can use Exchange Traded Funds (ETF) or Mutual Funds to get exposure to a basket of blue chip or penny stocks – maybe via industries or countries. You can also use various financial derivatives, such as Contracts for Difference (CFD), to profit from short term price bullish and bearish price movements.

 

Each option carries its own pros and cons and will weigh differently in your portfolio in terms of risk vs reward. So again, research and thorough understanding is crucial to make the right choices in constructing a solid portfolio.

 

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