Last Updated on 10 February, 2024 by Trading System
What Are Penny Stocks?
Penny stocks refer to smaller stocks of small companies that trade at lower than 5$ a share. Some penny stocks trade on exchanges, while most are bought and sold through over-the-counter (OTC) transactions.
Penny stocks are most often stocks of small companies that trade at a price of a few dollars. Some years ago, all stocks trading below $1 were categorized as penny stocks by the SEC (U.S. Securities and Exchange Commission ). However, today the definition encompasses all stocks that trade at lower than $5.
Normally penny stocks suffer low liquidity which makes it hard for investors to enter and exit their positions. Low liquidity also makes penny stocks the perfect target for market scams such as pump and dump scams, which is a danger that investors need to consider.
As we are about to learn, penny stocks are for risk-taking investors. However, in order to capture those high returns that accompany high risks, understanding Penny Stocks is a prerequisite. In this article, we will cover what penny stocks are, what risks are involved, and if you should invest in penny stocks or not.
Should You Invest In Penny Stocks?
Judging whether different investments such as Penny Stocks are useful to an investor depends on why the investment is being made. In general, there are two types of investors:
1.) Professional investors who invests for a living.
2) Investors who actively strive to maximize their returns from their savings.
It’s becoming ever more necessary to join one of these two groups. This is because in today’s world, you need returns on your investments to fight against inflation of important products and services. Take the example of college education. According to Finaid, a girl born today will have her tuition fee quadrupled by the time she turns 18. In such inflationary times, saving without investment is simply not an option.
Investing in Penny Stocks can be a good option for both types of investors, if risk all the risks, which will be covered later, are managed correctly!
What To Consider Before Buying Penny Stocks
An investor has to ask themselves two questions before deciding to invest in Penny Stocks or not.
- First, they have to ask themselves if they cope with the volatile nature of Penny Stocks. Penny Stocks differ from other investments because of their volatility and lack of security and are at the higher end of the spectrum when it comes to volatility. Therefore, prudent investors rarely hold a majority of their wealth in Penny Stocks. Furthermore, Penny Stocks are less secure because they are open to scams and are often issued by firms with very weak fundamentals. Therefore, a stomach for uncertainty comes in handy when investing in Penny Stocks.
2. Second, if investors decide on investing in Penny Stocks, they have to figure out what category of penny stocks they want to invest in. Officially, the SEC considers stocks under $5 to be Penny Stocks. However, experience shows that lumping all Penny Stocks to be under one price is a mistake and one of the best ways is to categorize them on the basis of their price. That Price in-turn determines the types of stock issuers, level of security, volatility levels and the best strategy for investing. It’s an investor best practice to categorize Penny Stocks into four price ranges. Below you see an example of how investors could rank penny stocks into different risk levels depending on their price.
As you can see, the lower the price, the higher the risk:
| 1 | NYSE or NASDAQ Grade Stocks | $1 to $5 |
| 2 | Slightly Dangerous Stocks | Under $1 to $0.01 |
| 3 | Toxic Stocks | Under $0.001 |
| 4 | Bait Stocks | Under $0.0001 |
Where Do Penny Stocks Trade?
1. On Exchanges
Those stocks that sell in exchanges such as New York Stock Exchange (NYSE) are less risky than OTC stocks. This is because the very requirements for being placed on the exchange is a mark of competence for the enlister. In contrast, entering into OTC markets is much easier, especially as a Pink Sheet stock. Ease of entry invites compromised firms into the market. These compromised firms then take unlucky investors for a ride that only ends with lessons that are learnt the hard way.
2. Via OTC:s
OTC counters have much smaller volumes of trade as compared to stock exchanges. This lack of liquidity has some serious implications on realizing returns from one’s investment. Let’s say an investor knows that the price of their stock has peaked and would like to realize their returns. If he owns 100,000 shares, he might be surprised to find that he can only sell a thousand shares a day. This will force the investor to either drop the price or only realize 1/100th of his/her potential returns. Though Penny Stocks may be sold via different fronts, the firms issuing them have some very basic common characteristics.
Pros of Investing in Penny Stocks
Let’s start with the advantages:
1 Investments Can Rise to The Sky
For starters, Penny Stocks do provide a big advantage for the stock broker in terms of potential returns. There is no other market where returns of 1000% can be repeated over and over again, that too in short-term investing.
2 Low Capital Requirements
Apart from giving good returns, Penny Stocks offer very low starting investment. With $5 one can own 1,000 shares in five different companies. This means that anyone can enter the Penny Stocks market without compromising their family budget.
3 Opportunity to Catch Trends Before They Start
Third, Penny Stocks allows an investor with niche knowledge of an industry to cash in on their knowledge. An example in today’s world would be cannabis stocks. A person who is intimately aware of cannabis production will be able to select the right Penny Stocks that might become a star stock of the future.
Cons of Investing in Penny Stocks
In contrast to these three strong advantages, Penny Stocks also have a lot of disadvantages as well.
1.Require Active Attention
For starters, Penny Stocks are very volatile. This makes them a bad option for passive investment. This means that investors who don’t invest for a living have to actively watch their investments in order to make good returns[6]. This might not be possible for some investors who have to work day jobs or take care of household chores.
2. Illiquid Investments
Apart from requiring active attention, Penny Stocks are also not the most liquid of the investments. Lack of liquidity can be a problem for middle-class income individuals as well as for investors with large holdings who want to capitalize on their returns.
3. Not Really an Investment
Lastly, and most importantly, Penny Stocks investment is not actually investment but more of a speculation. This is because the types of firms that issue Penny Stocks are very unreliable and require insider information to make good returns.
4. Risk of Buying a Scam
Third, Penny Stocks are also some of the most scam ridden investment options in the market. These scams come in all shapes and sizes and could make you incur great losses!
Summary
Of course, all these disadvantages will have the greatest impact if investors forget to consider them while investing. After considering the Pros and Cons of Penny Stock investment, if an investor decides to take the plunge, they will need to know the strategies of this market. Knowing a strategy and not acting on a whim is key to making money on penny stocks!
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Two Major Strategies of Investing In Penny Stocks
Success in Penny Stocks investing lies in making sure that one follows the two principles of an investments strategy. There are many to choss
- Avoid mistakes
- Always meet the checklist, before buying penny stocks ( You will be presented with one soon)
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Most Common Mistakes
Penny Stock investors tend to have high turnovers. Frankly, they cannot be blamed because the field is littered with return-destroying pitfalls. There are many pitfalls not to fall into, and some cautious individuals will use them as a justification to steer clear of the market.
However, prudent investors know not to throw the baby with the bath water. They know that avoiding these pitfalls starts with identifying them:
Mistake No 1: Going anywhere near Pink Sheet investment
One of the biggest mistakes is investing via Pink Sheets. Remember, how we told you that you can invest in Penny Stocks via exchanges or OTC markets? Well, there are two types of OTC markets:
- Over the Counter Bulletin Board (OTCBB)
- Pink Sheets.
The main difference between the two is that the firms that sell their stocks on OTCBB platform are obligated to submit their financials with the SEC. This gives an investor something to base his decisions on[7]. Stock issuers in Pink Sheet exchanges are not obligated to provide any financial or business information that will help the investor make an informed decision.
Apart from their non-transparency, Pink Sheets also contain many other deal breakers. These include the fact that Pink Sheets have lower volume of trade as compared to OTCBB market. Furthermore, the small cap-size of Pink Sheet markets leaves them open to price manipulation tactics such as pump and dump
Fact: New investors need to be aware that those shares that are traded on OTCBB market carry an “OB” suffix while those shares that are traded on Pink Sheets carry a “PK” suffix. Further classification is also available from different OTC markets.
Mistake No 2: Trading Penny Stocks on Margin (borrowing money to trade)
Borrowing money to invest in Penny Stocks is always a bad bet. This is because, in order for any venture to turn profitable, one needs a very predictable pay-off mechanism. Penny Stocks are the exact opposite of stable and predictable investments. Furthermore, with borrowed funds, you have a very real possibility of earning negative returns. This happens when you lose all of your borrowed money in Penny Stocks investments. Now the investor has to pay the principle plus the interest. This type of investors not only make a bad investment decision in the short-run but also compromises their long-term financial health, especially if they have compound interest clauses in their loan contracts.
Mistake No 3: Not Knowing the Industry That One Is Investing In
As Warren Buffet said, “Risk comes from not knowing what you are doing”. This applies really well to investing. To give you an example, lets look at the power sector. A novice investor might sell all shares for oil-based power producer once she realizes that solar power is the future. However, an investor who really knows the power sector will invest in oil-based power producers that operate Peaker Plants. Similar examples can be found in all industries. Not knowing the industry will stop you from spotting the winners and assessing the general situation in the industry. Moreover, it also leaves the investor open to manipulations by “market gurus”. It’s always easier to deceive a blind person. Apart from knowing the industry, it is also more prudent to trust the industry rather than a few firms.
Mistake No 4: Expecting to Beat the Market Every Year
Picking the right industry can produce good returns. However, some investors fall into the mistake of always picking a specific company for investment. Putting all money in one investment vehicle is always a big mistake and massively increases the risk for the investor. Unless the investor is in possession of specific insider information, such positions should be avoided. Instead, the investor is advised to diversify her investment among different firms within an industry.
Mistake No 5: Having Penny Stocks as More Than 10% of Your Portfolio
In general, it is good practice to have 80% of your investment in low-risk stable returns investments and 20% as high-risk high returns investments. Well in following such a scheme, one should ensure that Penny Stocks don’t exceed 10% of one’s portfolio. Having more than 10% of one’s portfolio in Penny Stocks is too much of a risk.
Mistake No 6: Investing In Stocks Below $0.01
Investing in Penny Stocks that are priced at a penny or lower can seem highly alluring. This is because a price change of a single penny can give upwards of 100% returns. However, investors need to avoid these stocks for a few reasons. First, Experience has shown that it is such stocks that are often operated by the shadiest of the organizations. This is especially true of triple zero stocks i.e. stocks valued around $0.001. Usually, the manipulator will buy the stock at $0.0001 and then create a false hype. Afterwards, they will dump that stock while making 1000% return, often at the cost of other investors. While looking at such stocks, a simple of rule-of-thumb of avoiding them all-together works really well.
After avoiding these mistakes, the investor can hope to survive their entry into the market. Now, they can start thinking about how to thrive. The best way to thrive is to be meticulous and follow a set of precautions before making every trade.
Checklist For Each Stock Purchase
The famous quote “Victory loves preparation” applies to Penny Stocks as well. Therefore, for every trade, the investor needs to be willing to take specific precautionary actions. With time, these precautions will become second nature to the investor. Investing in these habits will pay off in the future with good returns on investments. The checklist for Penny Stocks investment is as follows:
1. Don’t Risk More Than 1 or 2% of Your Capital In every holding!
2. See If The Stock Has Enough Trading Volume
3. Have A Fair Idea of When You Will Sell The Stock
4. Find the Quality of The Stock.
1. Don’t Risk More Than 1 or 2% of Your Capital In every holding!
Ensure that the amount that you invest will not make any single purchase more than 1 or 2% of your total holdings. You can do this with your very first trade by targeting 50-100 firms in your first purchase. You can further go ahead and do this for different sectors. One example would be to not have more than 10% of your investment in any one sector.
2. See If The Stock Has Enough Trading Volume
The investor does not want to end up in a situation where a good stock position cannot be exploited. A useful rule of thumb involves buying enough shares to sell them within a day’s volume. If an investor does not follow this advice they will have to compromise on the price in order to makeup for the falling price.
3. Have A Fair Idea of When You Will Sell The Stock
Unlike other stocks, passive investment does not work with Penny Stocks investments. Rather Penny Stock investment has to be an active affair which involves good judgment on part of the investor. Wise investors might secure small gains rather than wait for bigger ones. This is so because long-term investment in way too risky and even the large rewards of Penny Stocks do not cover such large risks.
4. Find the Quality of The Stock.
This is the most important item on the checklist. Finding the quality of the stocks simply means checking if the stock has the potential to give high returns. Checking the quality of the stock entails a number of actions which are listed as follows:
- Checking the team that is leading the company: successful managers have a history of producing a string of wins. This applies to Penny Stock companies as well. Therefore, having a good management team is a good sign that an investment will deliver upon its promise. The investor needs to be reminded that the bar for Penny Stock managers is lower than fortune 500 companies and they should be judged as such.
- Read the business fundamentals: Penny Stock issuing firms may not have the largest caps, however, a promising business should be able to bring good fundamentals to the table. A look at the SEC filings should be able to show good fundamentals. Apart from looking at the numbers, one also needs to look at the frequency of numbers. As a rule of thumb states that transparent firms are transparent because they have nothing to hide.
By following this list meticulously, investors can hope to survive the Penny Stock market in the long run while bagging good returns on their investments. Now it’s time to go out into the world and actually invest in Penny Stocks.
Warning: This checklist is not complicated at all. Yet, many investors lose out because they do not have the discipline to carry out this list for all their trades. Remember, the world is ruled by doers.
How Do I Get Started?
You can trade penny stocks via a Depository Trust Company (DTC) in order to trade at exchanges such as NYSE or NASDAQ.
However, DTCs often deter Penny Stock investment by adding additional surcharges that are more than the value of the trade itself. Instead, brokers are a good option for trading on the OTC market.
When you are selecting a broker, for OTC trading, here are some factors to look for:
- Ensure that the broker does not have separate fees for lower trading volumes or lower prices
- The broker should have no monthly fees- Investors often find it suitable to not trade for months at a time
- Ensure that the broker has the following:
- Flat rate per trade commission
- Live margin calculation
- Access to multiple OTC markets.
Conclusion
Investors who understand Penny Stocks can gain from investing in it. However, they have to make sure that they avoid pitfalls while maintaining discipline in initiating trades involving Penny Stocks. Furthermore, an investor can use DTC market or OTC trades to execute their trades. Within the OTC market, the investor will have to consider a few pointers when selecting a broker.
FAQ
Is trading Penny Stocks on margin a good idea?
Trading Penny Stocks on margin is generally a bad idea. The unpredictable nature of Penny Stocks can lead to negative returns, and borrowed funds can result in financial losses for the investor.
Is investing in Penny Stocks below $0.01 a good idea?
Investing in Penny Stocks priced at a penny or lower may seem alluring, but it comes with risks. Stocks valued around $0.001, especially triple zero stocks, are often operated by dubious organizations. It’s recommended to avoid such stocks altogether.
How can investors assess the quality of a Penny Stock before investing?
Assessing the quality of a Penny Stock involves considering factors such as financial health, market reputation, and adherence to SEC regulations. Thorough research and due diligence are essential to make informed investment decisions.