The world of stock trading is a fascinating one, as there exists no rulebook as a guide to the stock market; it is unpredictable. Some gain thousands of dollars, while many lose more. Most of these trades happen on the high-priced stock, but among billion-dollar valuations, it is easy to dismiss penny stocks as they seem to be worth a penny or less. But, are penny stocks really a penny?
Penny stocks are seldom a penny. The U.S. Securities and Exchange Commission (SEC) defines these as stocks trading at less than $5 per share. These are usually floated by small businesses with very low to no profits and typically cost less than $3.
In this article, you will learn what a penny stock is and how exactly does one trade them. Additionally, you will find out whether penny stocks are even worth investing in and why they are declared to be a risky investment.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
What Are Penny Stocks?
A penny stock is considered to be worth $5 or less. Typically, these are traded by over-the-counter transactions through the OTC Bulletin Board or privately owned groups such as OTC Markets Group. They can also be found on Pink Sheets, a listing service like the OTC Bulletin Board. However, it is much less reliable because Pink Sheets is only a quotation publisher with no listing requirements. It is also not regulated by the SEC.
Although you will find a few penny stocks on official and large stock exchanges, most of them are never approved due to their high-risk, low capitalization, and lack of buyers. You can still purchase them through your stockbroker; however, he will almost always advise you not to.
Penny stocks are infrequently traded because they come from firms either on the verge of bankruptcy, running on shallow operations, or just starting up. Due to this, it isn’t easy to find a buyer for these stocks. They have very low liquidity, making them more unpredictable than any other stock.
All stocks come with fluctuations, but penny stocks are more volatile than any other type of stock. This is because they do not have many people interested in them, so even a few purchases will set their prices either too high or too low. Unpredictability is a part of the stock exchange, but an investor should only consider buying these stocks when they have a high tolerance for risk.
Why Are Penny Stocks Attractive?
While many investors will steer clear of these stocks, many are also interested in them. If you have seen The Wolf of Wall Street, you will understand that being able to bear risks comes with exchanging stocks. You have to be ambitious about making profits and, to some extent, find some excitement in them. In the case of penny stocks, it is ironic that what makes them so risky is what makes them so attractive.
A penny stock is highly volatile, which means higher profits but also higher losses. Let’s take an example, suppose you invest in a penny stock worth $0.4, and the price shoots up to $1. You decide to sell it, which would give you a profit of 150%. We’re not saying all investments in penny stocks will result in such profits, but it cannot be denied that a well-informed trader can make some serious money trading penny stocks.
It has happened that many have made profits, and you are likely to find a few investors with stories about how penny stocks helped them earn thousands, sometimes even millions. This volatility helps them achieve this, and as noted above, if done right, it is possible to make a healthy return trading these financial instruments.
The Risks of Penny Stocks
Investment in a penny stock is almost always a risk. This is because the scenario of actually being able to sell them is an illusion. Investors fall for this. They go ahead and buy large amounts of these stocks. What they often forget is that penny stocks have very low liquidity and have very few buyers.
Even if you stock up on these to sell them, you will face two problems; finding an accurate price and finding buyers. The standard of reporting and regulating these stocks is meager, which means prices are unreliable, subject to high fluctuations, and infrequent buyers. At the end of the day, you will be left with a bunch of worthless stocks and no way of getting rid of them.
Scammers and frauds are easy to find in the world of penny stocks. They prey on inexperienced investors who quickly fall for these prices’ face value, leading them into net losses. They do this through specific schemes.
Pump and Dump
This happens when fraudulent schemers will push up the interest and price of stocks of a small or unknown business. Some investors, attracted by these high fluctuations, will buy their stocks, expecting them to rise further. Due to a lack of buyers, their own purchase will raise their prices, and the bad guys will rush to sell these stocks at this price. Ultimately, they pump the price and then dump them at these prices.
Guru Schemes
Advertising is everything. The right advertising of a product is what forms an opinion in the mind of the buyer. The same goes for a penny stock. Often, ‘gurus’ will come forth with illusionary words and success stories. Their advertising patterns will lure them in. New investors falling for this will listen to their ‘advice’ and set themselves up for a loss.
It is essential to beware of these scammers, which is once again problematic. The OTC means of purchasing these stocks makes it difficult to filter out which companies are a scam and which companies are actually looking for money.
Short and Distort Scams
These are the flip side of the pump and dump schemes. Scammers will use short-selling to make a profit, relying on the price to fall. A scammer will borrow penny stocks from a broker at a very low cost and sell them immediately on the market.
If the price decreases, he will scoop up these stocks again at the lower price, returning them to the lender and keeping the difference for himself. What makes this worse is that they influence the price fall by spreading false information about the company’s stocks, setting up investors who are currently holding the stock for a loss.
Is There a Way to Succeed Trading Penny Stocks?
Penny stocks require research. There are two ways to make money in penny stocks. The first leverages fundamental analysis. For this strategy, a company’s underlying business is what matters. You will need to find a legitimate company with substantial profits and continuous operations, even if they are low.
The second one relies on knowing the market better than the average person. It is easy to find a ‘shell company’ when finding a penny stock, and these are the companies that are targeted for pump and dump by scammers. If you wish to make money by leveraging such stocks’ temporary rallies, you must exit before the scammers manipulate the prices to crash the stock price.
In contrast, for the first method, research into the company’s financials is vital; make inquiries about backgrounds, ask your stockbroker for advice, try to find annual reports that are accurate and valid. Another piece of advice is to read footnotes on annual reports because that is where information is hidden. Penny stocks may sound scary, but there exist actual small businesses looking for investors to boost operations.
Author’s Recommendations: Top Trading and Investment Resources To Consider
Before concluding this article, I wanted to share few trading and investment resources that I have vetted, with the help of 50+ consistently profitable traders, for you. I am confident that you will greatly benefit in your trading journey by considering one or more of these resources.
- Roadmap to Becoming a Consistently Profitable Trader: I surveyed 5000+ traders (and interviewed 50+ profitable traders) to create the best possible step by step trading guide for you. Read my article: ‘7 Proven Steps To Profitable Trading’ to learn about my findings from surveying 5000+ traders, and to learn how these learnings can be leveraged to your advantage.
- Best Broker For Trading Success: I reviewed 15+ brokers and discussed my findings with 50+ consistently profitable traders. Post all that assessment, the best all round broker that our collective minds picked was M1 Finance. If you are looking to open a brokerage account, choose M1 Finance. You just cannot go wrong with it! Click Here To Sign Up for M1 Finance Today!
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Conclusion
At the end of the day, penny stocks still exist and trade-in substantial quantities. They indeed come with high risks of scams and losses, but it is also a fact that trading penny stocks can make profits. Regardless of all the drawbacks, investors are willing to find the right spot for these stocks because they know that although returns are not promising, the gains will be impressive if done right.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
Affiliate Disclosure: We participate in several affiliate programs and may be compensated if you make a purchase using our referral link, at no additional cost to you. You can, however, trust the integrity of our recommendation. Affiliate programs exist even for products that we are not recommending. We only choose to recommend you the products that we actually believe in.
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