For many investors, stocks that cost less than one euro sound like a tempting investment. The supposed bargain papers, however, have enormous risks that are often extremely underestimated by many investors.

• Visually favourable stocks are not necessarily cheap
• Trading volume of penny stocks is approaching the 2000 level
• A total loss must always be taken into account

Penny stocks are stocks that are traded at a price of less than one euro or for a few cents. This magical price threshold of less than one euro is in the USA, in contrast to Europe, at five US dollars. Accordingly, all stocks with a market value of less than five US dollars are referred to as penny stocks in the USA. This somewhat different definition goes back to the regulations of the major US stock exchanges, which stipulate a minimum price of five US dollars for a listing.

The psychological effect of penny stocks

The main reason for the great popularity of stocks that cost less than one euro or less than five US dollars can primarily be explained by a psychological effect. The extremely cheap price suggests, especially to inexperienced investors, that the respective share is particularly inexpensive and thus offers high price increases. Because in order to achieve a return of 200 percent, a penny stock, for example, “only” has to increase from 20 cents to 60 cents, while a blue chip has to climb from 50 to 150 euros.
The probability that a share will rise from 20 to 60 cents seems to many investors to be significantly higher than the possibility that a share will rise from 50 to 150 euros. However, the percentage gain is the same in both cases.

However, this psychological effect is also often exploited by larger corporations, which optically cheaper their own shares with the help of a stock split. For many private investors, a share with a price of 25 euros is much more attractive than a share that costs 400 euros, for example. In this context, however, many investors seem to ignore the fact that the price of a share has nothing to do with the value of a company.

Not every penny stick is a “pig in a poke”

A share that is trading at around one euro does not necessarily have to be a speculative penny stock. In countries like Australia, Hong Kong and Great Britain it is even more the rule than the exception that some stocks have very low market values. For example, the shares of the British telecommunications group Vodafone are “only” quoted at around 1.50 euros, although the company, with a market capitalisation of over 40 billion euros, is one of the largest mobile communications companies in the world.
A very similar constellation can be seen at the Australian aluminum producer Alumina . Despite a solid valuation and a market capitalisation of around 3 billion euros, the Group’s share is only quoted at around 1.10 euros per share.
Accordingly, investors who want to distinguish a blue chip from a penny stock should not only take into account the price of the respective share, but above all also the total market capitalisation. Because classic Penny stock companies are often only a few million and not billions.

Gambling papers keep Wall Street busy

New trading platforms and apps, which are becoming increasingly popular in the USA, are currently ensuring that more and more, mainly young private investors, are trying their luck on the stock market. It so happens that six companies alone, each trading at around one US dollar, sometimes accounted for almost a fifth of the total US trade volume.
These penny stocks include companies such as Zomedica and Sundial Growers . While Zomedica produces various medicines for animals, Sundial Growers is a Canadian pharmaceutical company that produces various types of cannabis.

The bigger fool theory

Speculators who buy and push individual pennystocks with the help of social media such as Reddit usually follow the so-called greater fool theory. This theory describes an investment strategy that assumes that a share can be bought well above its fair value, as there is certainly another investor who buys the paper at an even higher price. This buyer is then referred to as a greater fool, as he pays an even higher price for the completely overvalued stock.

Small market capitalisation can be a problem

“Probably one of the biggest risks [speculators] face is the size of businesses in general,” continued Shipe. Since the market capitalisation of Penny stock companies is usually very manageable, they offer less protection for investors than standard values. Difficulties can arise very quickly when selling, as smaller companies often only have a low trading volume.
In social media, chat rooms and forums, individual users can use positive news and publications to ensure that the trading volume and interest in a particular stock increase, but such an influence borders on price manipulation.

Beware of pump and dump!

Penny stocks in particular are therefore very susceptible to so-called pump-and-dump systems. The classic pump-and-dump (inflation and discharge) is a scam that primarily aims to exclude smaller private investors.
For this purpose, various reports on smaller companies are published and distributed, often by dubious stock market letters or dubious stock market gurus, which are intended to encourage the purchase of the respective penny stocks with freely invented price targets. However, behind the often very elaborate purchase recommendations, mentions and press releases are fraudulent organisations or individuals who have already bought the respective shares before the first major publication or recommendation and are therefore just waiting for it. get rid of them with a hefty premium. In Germany, such a method is also known as a scalping strategy.

Pennystock – more of a betting slip than a share

Investors who are determined to invest their money in penny stocks should definitely keep the enormous risks in mind. With penny stocks in particular, it is more the rule than the exception that the investment ends in a total loss in the long term.
“Just make sure you can afford to lose and have rules about how to speculate,” Cole Financial Planning’s Scott Cole said in a Bloomberg interview. Basically, of course, nothing speaks against manageable investments in the field of penny stocks, but in this context one should speak of speculative bets rather than sensible investments. Pierre Bonnet / editors finanzen.net

This text is for informational purposes only and does not represent an investment recommendation.

Make money with falling stock prices? You can do that with reverse index certificates. In this guide we explain exactly how you can achieve returns with certificates against the trend and where to find the best reverse index certificate – this is how certificates work.

What is a Reverse Index Certificate?

With Reverse Index Certificates (also called Bear Index Certificates or Inverse Index Certificates) investors achieve returns with the negative performance of an index. A reverse index certificate therefore shows the inverted performance of an index. This is measured from a certain price mark, the base price (also reverse level). When the certificate is issued, this base price is set well above the current index level – roughly twice the level of the index. The price of the certificate is then the difference between the base price and the current index level. Falling index levels therefore increase the price of the certificate, while a rising index has the effect of reducing the price. Due to the fixed base price, falling prices of the certificate result in a leverage effect that is all the greater

Reverse index certificates must not be confused with index certificates on so-called short indices, such as index certificates on the ShortDAX index. Although investors with these certificates also participate in falling prices, their constant leverage means that they have a different risk / reward profile.

When is it worth Investing in a Reverse Index Certificate?

Investors can opt for a reverse index certificate if they expect the underlying index to decline. Reverse index certificates are usually issued without a time limit and are suitable both for pursuing short-term trading strategies and for temporarily hedging a portfolio.

What are the risks of Reverse Index Certificate?

There is a risk of investing in reverse index certificates in rising prices of the underlying asset – this leads to losses in the certificate. Another risk lies in the possible leverage effect of the product: If the index has already risen significantly when the certificate is purchased and is tending towards the base price, then the certificate is cheaper than a comparable direct investment (i.e. the covered short sale of the underlying) and consequently has a Leverage on. The closer the index gets to the strike price, the higher the leverage. In the worst case, if the base price is touched or exceeded, the reverse index certificate expires worthless and investors suffer a total loss.

Investment in a Reverse Index Certificate

Investors who assume that the ABC share index will fall in the future can benefit from a reverse index certificate if this forecast occurs. In order to achieve the reverse mapping of a stock index, a base price (reverse level) is first set at which the inverted performance of the index is shown.

If the ABC index is quoted at 10,000 points on the day of issue, the issuer sets the strike price at twice this value. The definition of the base price with a large difference to the current index level serves to ensure that the product (at least initially) does not have any leverage effect.

If you subtract the index level from the base price (20,000 – 10,000 index points), the result is the value of the short position in the index of 10,000 points. The price of the reverse index certificate is based on this value, multiplied by the subscription ratio; it is 100 euros. At this point in time, the leverage that results from the comparison with an alternative direct investment is by definition -1.

In addition, the reverse index certificate is equipped with a barrier below the base price, which serves to avoid the so-called gap risk for the issuer. The issuer always takes on this when the underlying closes just below the strike price. It consists in the fact that the underlying could open above the strike price on the next trading day and the issuer suffers losses if its hedging position is liquidated. In principle, this barrier has no influence on the price of the certificate.

If the index falls by 500 to 9,500 points, the price of the reverse index certificate rises to 105 euros; the leverage, however, decreases as the certificate price increases. If, contrary to expectations, the index should rise by 1,000 points to 11,000 points, the price of the certificate will drop to around 90 euros. The reduced price also means a higher leverage effect.

Investors participate in a reverse index certificate from sharply falling index levels up to a (more theoretical) index level of zero points. In this case, the repayment amount or sales proceeds of the reverse index certificate would correspond to the base price (reverse level) multiplied by the subscription ratio of EUR 200. If, on the other hand, the underlying index rises to or above 20,000 points, investors in the reverse index certificate suffer a total loss.

How do Reverse Index Certificate work?

Since the issuer generally does not enter into an opposing position to the investor, he hedges himself in the market. The easiest and fastest way to hedge a reverse index certificate is to sell the underlying asset short.

However, instead of borrowing all 30 DAX shares in the current weighting from another market participant and then selling them short with a reverse index certificate on the DAX, the issuer will take a short position in the corresponding DAX future. Futures are also used to avoid delivery and storage problems with raw materials. The futures market not only offers permanently high liquidity, but also the lowest transaction costs, so that reverse index certificates can be offered with moderate bid-ask spreads. (Also Read: Slack wants to expand everyday digital work with new functions)

Important: the more liquid a future and the underlying stock market, the smaller the bid-ask spread.

Only if no index future is available or if it is not liquid enough, the index is replicated via direct short positions in the individual stocks (or the representative stock baskets). However, this can result in additional costs for the issuer. Alternatively, short positions in individual stocks, for example a basket of stocks, may not or temporarily not be mappable.

Basically, the more specific the index construction and the lower the liquidity and market capitalisation of the individual index components, the greater the costs for the issuer of hedging. As a rule, the transaction costs incurred are passed on to the investor in the form of an annual management fee.

If the investor sells his reverse index certificate back to the issuer at any point in time, the issuer immediately dissolves his hedging position. If an investor withdraws from the reverse index certificate with a large profit, the issuer is always in a position to actually pay out this amount thanks to his hedging – after all, he holds the same position as the investor. If, on the other hand, the issuer’s position is in the red because the market has risen, then investors also realise a loss. In principle, the issuer acts free of conflicts of interest through its hedging transactions. (Also Read: Big discount in valuation: are quality stocks on the verge of recovery?)

Price factors for Reverse Index Certificate

• The price of a reverse index certificate is subject to fluctuations, for which changes in the price of the underlying asset – i.e. the index or commodity – are responsible.
• Since the product structure of reverse index certificates does not contain any option components, the sensitivity indicators for options are not relevant here.
• The only influencing factor on the price of the reverse index certificate is the price development of the underlying (key figure: delta).
• Falling prices of the underlying have a positive effect, while rising prices have a negative effect on the price of a reverse index certificate.
• The treatment of dividends within an index is regulated by the index concept (price or price index vs. performance or total return index).
• A change in the dividend expectations for individual or all index components does not affect the price of a reverse index certificate.

How to find right Reverse Index Certificate

Investors should develop a differentiated market assessment before buying, as reverse index certificates are only suitable for falling markets. With regard to their individual willingness to take risks and expected returns, it makes sense for investors to deal in detail with the dividend treatment in the index concept (performance or total return index vs. price or price index?), The degree of diversification (how many companies from how many sectors which countries are included?) and the existence of currency hedging .

If some or all of the shares in an index are quoted in a foreign currency, the investor with the index certificate assumes an exchange rate risk . Investors who want to hedge against currency effects should choose exchange rate-hedged Quanto Reverse Index Certificates. The quanto mechanism eliminates all risks, but also the chances of exchange rate changes, in favor of increased calculation security. Since the hedging of Quanto Certificates is complex, the issuer will usually charge an annual Quanto fee. When investing in raw materials, special features and additional risks must also be observed.

When it comes to the term , investors should make sure that they use a reverse index certificate with an unlimited term. However, in accordance with the conditions of the sales prospectus, the issuer generally reserves the right to terminate the certificate under certain conditions, regardless of the theoretically infinite term, and then to repay it at an officially determined settlement price.