Avoiding the Pitfalls: Navigating Dilution in Penny Stock Trading

Dilution occurs when a company issues more shares of its stock, which dilutes the value of existing shares. This scenario is common with penny stocks and can mean bad news for investors because it cuts into their profit potential.

How Dilution Happens

In many ways, dilution happens in the penny stock investment environment, and investors must stay alert. When researching how to find penny stocks, you can read more on ways dilution happens and how that impacts your investment.  Here is a quick overview.

Stock Split

A stock split is the primary causative path, which means that the company has oversplit its current shares excessively into small ones.

Let's say company X has 1000 remaining shares and does a 2-for-1 split. The company will now have 2000 shares, which dilutes the value of an investor's shares by half for each.

New Shares

Dilution can also occur through the issuance of new shares. This can happen when a company raises capital through a public offering or a private placement. When a company issues new shares, it dilutes the value of existing shares.

Companies may roll out new shares through secondary offerings to raise capital. Moreover, these offerings usually take the form of a follow-on public offering (FPO) or a private placement.

The moment the new shares are issued and sold to new investors, the number of the company's shares in the market increases, leading to an overall dilution of value for existing shareholders.

Convertible shares and stock options

Penny stock companies may issue stock options to employees or convertible shares to stakeholders.

The holders can convert these instruments into common stock at a given price or ratio. When conversion happens, the number of shares in the market increases and dilutes value for investors.

How to Avoid the Pitfalls of Penny Stock Dilution

Dilution may make sense if a penny stock company issues new shares with funding long-term growth. But if the dilution reduces the value of the existing stock without any results in company value growth, then that's a problem. Here is what to do.

Track company news

Stay informed about the penny stock companies that you invest in. By tracking the company's news and financials, you'll be the first to know of their plans to issue new shares and decide to exit quickly before the value erosion hits.

Don't make an impulsive sale

When penny stock prices plunge because of dilution, don't impulsively decide to sell. You must carefully assess the situation and decide when to take a long-term investment approach. The dilution could work out profitably in the long run.

Watch the timing

A company issuing new shares before the financial year report or a product launch may be trying to manipulate the minds of its existing and new investors. Exit as soon as you get a good chance.

Invest in more companies

Diversification is the number 1 commandment in the investor's bible 2013 always diversify your portfolio, whether penny or blue chip stocks. But if there is dilution on the horizon, you will need diversification more than ever to cushion yourself from the potential losses of the diluting company.

Don't buy more diluted stock

A penny stock company that has issued too many shares may signal that the company is either saddled with debt or needs help raising capital. In either case, that's not an attractive investment.

Track company history

If it has happened before, it will probably happen again. Before deciding to invest in a penny stock company, look at its history of finances, and if there is a track record of dilution, including frequent stock offerings over a short period, find a better company to invest in.

You may find this information from industry news, press releases, financial statements, and SEC filings.

Conclusion

Dilution is a common occurrence in penny stock trading. It can significantly reduce the profits that investors make from their investments. However, there are several things investors can do to avoid the pitfalls of dilution.

By doing their research, investing in companies with a strong track record of profitability, and being patient, investors can help to minimize their risk.