What happens to its risk profile if a stock’s nominal share price falls? The answer to this query has necessary implications for managing investor expectations and reducing portfolio turnover. Investors often deviate from their chosen long-term strategy attributable to emotional reactions to unexpected market movements. These market timing measures present their very own risk and complement the present risk of unpredictable markets.
Some would argue that volatility decreases as a stock approaches the lower end of the penny stock range because there may be an inherent threshold below which the value cannot fall. Others would argue that the stock is more sensitive to market movements because market conditions determine the corporate’s survival.
We examined what happens to a stock’s systematic risk and overall volatility when it becomes a penny stock, meaning its price falls below $5 per share. The results may surprise you. We have found that as a stock decreases in value, it becomes more sensitive to market movements. In other words, its beta increases and its overall volatility increases accordingly.
We have reduced the stock returns of all corporations listed on the NASDAQ and NYSE for 50 years. We examined stocks which have exceeded the $1 per share, $2.50 per share, or $5 per share threshold over a 50-year period. We recorded the cases where each stock crossed these thresholds for the primary time. We then noted the betas of the stocks before the edge transitions and compared them with the identical betas of the stocks two years after the transition date.
The results
The first interesting result’s that when a stock falls below the $1 threshold, its beta falls on average from 0.93 to 1.57. A beta greater than 1.0 signifies that the value of a stock is more volatile than the market as an entire, meaning that the value fluctuates more. With a beta lower than 1.0, the alternative is true.
The increase in beta from 0.93 to 1.57 for the stocks that fell below the $1 threshold represents a major shift in the danger profile. In fact, it’s statistically significant at 1%. At the $1 threshold, the typical penny stock has much higher systematic risk and overall volatility. And this variation is widespread. Stocks with negative betas increase on average from -0.62 to 1.14. Stocks with betas between 0 and 1.0 increase from 0.55 to 1.37. And stocks with betas above 1.0 rise from 1.95 to 1.88.
What happens to a stock’s systematic risk and overall volatility when it becomes a penny stock?:
| Beta before price drop | Beta 2 years after price drop | |
| Average price cut limit: $1/share | 0.93 | 1.57 |
| Beta below 0 | -0.62 | 1.14 |
| Beta between 0 and 1.0 | 0.55 | 1.37 |
| Beta higher than 1.0 | 1.95 | 1.88 |
| Beta before price drop | Beta 2 years after price drop | |
| Average price cut limit: $2.50/share | 0.90 | 1.56 |
| Beta below 0 | -0.55 | 1.01 |
| Beta between 0 and 1.0 | 0.52 | 1.27 |
| Beta higher than 1.0 | 1.90 | 1.94 |
| Beta before price drop | Beta 2 years after price drop | |
| Average price cut limit: $5/share | 1.00 | 1.07 |
| Beta below 0 | -0.56 | -0.51 |
| Beta between 0 and 1.0 | 0.47 | 0.50 |
| Beta higher than 1.0 | 2.02 | 2.17 |
The results illustrate that this drastic increase in risk (volatility) is entirely attributable to a rise in systematic risk, that’s, the movement with the market index. Notably, these results will not be attributable to mean reversion over time in betas.
At the high end of our study, we examined when stocks cross the $5 per share barrier. The results look completely different. Before a stock crosses the $5 threshold, its beta averages 1.0 and 1.07 afterward. The other beta levels at $5 per share showed the identical results. This confirms that the $1 threshold results are indeed attributable to the stock moving into penny stock territory.
The results support the notion that penny stocks develop into much riskier (higher volatility) as they approach the zero price sure and that this risk is attributable to a rise in systematic risk (increased sensitivity to market movements).
If you enjoyed this post, do not forget to subscribe.
