Last Updated on 13 January, 2021 by Samuelsson
You may have heard so many contrasting views about penny stocks — while some people say they are dangerous investment options, others claim to money trading them. It is, therefore, normal to ask whether penny stocks are worth investing in.
Investing in penny stocks can be a very risky adventure, but if you understand the peculiarities of this type of stocks and approach them the right way, you may be able to make money from them, and it could be worth it. However, if you are looking to invest long term, or put in a large share of your capital in penny stocks, that should be avoided! For long term investments, index funds or blue-chip companies is a much safer option, that will generate good returns over time!
But what exactly are penny stocks and why the varying opinions about them? Keep reading to find the answers to all your questions.
What are Penny Stocks?
Penny stocks, also called small-cap stocks, are common shares of small public companies that trade at low prices per share (less than five dollars per share). Also known as micro-cap stocks or OTC stocks, penny stocks were, in the past, considered any stock trading below $1 per share.
However, the U.S. Security and Exchange Commission (SEC) now classifies as a penny stock, any stock that trades at less than $5 per share. Unlike the blue-chip and mid-cap stocks, which trade on standard exchanges like the NYSE and NASDAQ, this type of stock usually trades on over-the-counter marketplaces — the reason they are called OTC stocks.
One of the OTC exchanges where penny stocks are quoted is the Pink OTC Markets Inc. (owned by OTC Markets Group Inc.). Another popular marketplace for penny stocks is the OTC Bulletin Board (OTCBB). But some penny stocks are also quoted on normal exchanges, even foreign stock exchanges.
Apart from the fact that they are associated with small private companies and trade at low prices, penny stocks are also characterized by other features. For example, the penny stock market is known to be very illiquid. Also, they are highly volatile, with wide bid-ask spreads.
However, their low prices make them attractive because of the potential to make huge profits when a winner is identified. So there are actually some benefits there.
The Potential Advantages of Speculating in Penny Stocks
As with any other stock investments, there can be many potential benefits to investing in penny stocks, in spite of the risks involved. Many so-called investment authorities will only tell you about the dangers, but the more the risk, the more the potential rewards.
Here are a few of the benefit of trading or investing in penny stocks:
1. Low prices
One of the main benefits of penny stocks is that they trade at very low prices. Although the SEC uses the $5 mark to define them, the truth is that many of them trade at pennies per share — very cheap. So it is possible to buy a lot of shares of a stock with a relatively small amount.
2. Ease of Access
Because of their low per-share prices, penny stocks are easily accessible to small investors. A trader doesn’t need a big capital to start trading in these stocks. With a few thousand — or even hundred — dollars, a trader can buy thousands and millions of shares in these stocks, which is not possible with higher-priced stocks.
The availability of online brokers like TD Ameritrade and E-Trade makes it possible for a trader can set up an account with a small deposit and start trading penny stocks. So the trader need not worry about raising the minimum capital required by normal brokers.
3. Huge Potential Returns
Another great benefit of penny stocks is their potential to generate huge profits on a relatively small investment. Because penny stocks are trading at low prices, if things turn out right and the stock you bought moves favorably, it can get to double, triple, or even more, of the price you paid for it. So the profit can be huge.
4. Quicker Moves
Penny stocks can make their moves in a matter of hours or a few days. It is quite common for a penny stock to make 50% or even 100% moves in a trading day. So with penny stocks, you have the chance to make reasonable money in a short space of time.
As a matter of fact, if you decide to trade in penny stocks, it’s best to approach it as a short-term or ultra-short-term investment. A penny stock is not an investment you buy and hold. Once you have made a good profit, you walk away.
5. Potential Future Winners
On some occasions, a penny stock may grow into a mid-cap stock, making huge returns along the way and increasing in real value. This is how most companies grow to become the big names they are today. In fact, by definition, many blue-chip stocks of today were once penny stocks.
Spotting this type of potential winners is very difficult. You will need to study the company’s management, products or services, and how important the industry is to society. Then, there is need for patience and belief, to be able to hold the stock for a long time.
Dangers of Investing in Penny Stocks
As you must have heard several times, investing in penny stocks is like grazing in dangerous territory, so don’t be fooled by the ridiculously low per-share prices. The dangers of investing in penny stocks are numerous, but here are a few of them:
1. Lack of information
To make an informed decision about any stock investment, an investor will need to get all necessary information about the issuing company, such as earning reports and information about the management. But this becomes an issue when it comes to penny stocks, as there is generally a lack of information about these stocks. Even when there’s one, the sources are often questionable.
For stocks that trade on standard exchanges, the SEC would mandate them to make the necessary information public. But since these stocks are not listed on major exchanges, they don’t release any information to the public.
2. Very Low Liquidity
Penny stocks trade might only trade a couple of thousand shares, or less, each day and do not attract institutional investors. As a result, they are usually harder to sell after acquiring them. Sometimes, penny stock investors are forced to lower their price to make the shares attractive to those who want to buy. This often leads to selling at a loss. Additionally, because of the low liquidity, a relatively small order from a single investor can affect the price.
Low liquidity is something that especially affects short term traders, since they are in and out of the market with very small profit margins.
3. Highly Volatile
A penny stock is typically volatile, and you know why — the liquidity is not there. Any sizeable order can significantly push the price in either direction, depending on the direction of the trade. That is why you see too many price spikes on the chat of any penny stock. And those spikes makes the analysis of the price action more difficult.
In addition, the bid-ask spread can be wide since there are fewer traders trading these stocks and there are no market makers — not trading on a standard exchange. Apart from worsening the already high volatility in these stocks, wide spreads can increase transaction costs.
Another reason why penny stocks can be so volatile, is that they are very susceptible to scams and rumors about the company.
4. Companies Without Track Records
Most of the companies behind the penny stocks are newly formed private companies without any track record. Others may be companies that are close to bankruptcy which normally have poor histories. With this kind of data, it becomes very difficult to estimate the real value of these companies. Thus predicting their long-term profitability is almost an impossible task.
5. Highly Speculative
Since there are very few ways to estimate the values of companies behind these stocks, penny stocks are generally considered highly speculative. Those companies may not even have proven products or services. The penny stock market is for speculators who want to make short-term profits — not good for investors with long-term outlook.
6. Lack of Regulation
The OTC marketplaces, where penny stocks trade, are poorly regulated. Unlike the standard exchanges, which have minimum standard a company must maintain to remain on the exchange, such as the total market value, number of shares, and timely reporting of earnings, the OTC marketplace have no minimum standard.
The minimum standards are regulatory mechanisms to protect investors. So the companies that trade on the OTC are not well regulated, making them prone to manipulations.
7. Easily Manipulated
Since penny stocks are illiquid and poorly regulated, they are easily manipulated. In fact, a lot of scams are associated with penny stocks.
In fact, let’s have a look at some of these scams!
Common Scams in Penny Stocks
There many ways fraudulent organizations use penny stocks to scam a lot of money from inexperienced investors. These are some of the most common methods:
Pump and dump
In this method, the manipulators will first purchase a huge number of shares of the stock they want to manipulate. They will then promote (pump) the stock through a number of ways to lure investors into buying the stock. As a result of increased demand, the price of the stock increases, and when the price has risen high enough, the scammers will sell (dump) their shares and walk away.
Dump and Dilute
The dump and dilute scheme is a scam run by the issuing company. The company repeatedly issues shares for no reason other than taking money from the investors. Later, the company would reverse-split the stock — investors exchange multiple shares for one share — to reduce the number of outstanding shares.
Here, the brokers are involved in the scam. In this scheme, a brokerage firm buys a large block of an illiquid stock from a large shareholder at a discount and then sells the shares to its clients at the market value. The broker hypes the stock to convince the clients to buy, knowing fully well that nobody wants the stock.
Know It all
In this sort of scam, a self-acclaimed guru promotes the idea of making huge returns from penny stocks using a special winning strategy. He will offer to teach you the winning strategy if you pay him some money. Basically, it’s all about selling a penny stock trading course. This type of scam is also seen in other markets, especially forex.
How to Make Penny Stocks Worth It for You
There two ways to speculate in penny stocks:
- Short-term trading
- Investing for long-term growth
For short-term trading, you are simply trying to time the market and benefit from the next price swing up or down. You can trade in either direction, and you don’t keep the trade for too long. Once the price has gotten to your target profit level, you close out and look for another tradable opportunity.
Short-term trading is the most favored strategy for playing the penny stock market. Technical analysis is generally used in this method, but you can also study the stock’s fundamentals.
Investing for the Long-term
In this method, you are basically searching for a viable stock with huge growth potentials — a future winner. It is not an easy task though. But you can reap huge returns if you can spot the next big winner.
To start, you must do your due diligence. Study everything you can about the company: its management, the type of product or services it offers, how important the product or service is to the society and how well the society has accepted it, and the competition in the industry.
Then, study the company’s financial performance over the years. Check the quarterly earnings and compare each quarter with the corresponding period in the preceding year. The aim is to find out whether the company’s earnings have been growing or not.
If after your study everything looks good, open an account with an online broker. But before then, you must decide how much you want to invest in the company. No matter how good your findings look, a penny stock is inherently risky, so you should not invest more than you can afford to lose.
Investing in penny stocks can be a very risky adventure, but if you understand the peculiarities of this type of stocks and approach them the right way, you may be able to make money from them. After all, no type of stock is without some form of risk — even blue-chip stocks can plummet at times.
However, you should never risk most of your money in penny stocks. If you are looking for long term stable growth, then blue chips or index funds is the way to go!
If you enjoyed this article you might also like our other articles answering common questions traders have!