Penny stocks have always seemed like bad news to the risk-averse average person but investors who have a high-risk threshold are still willing to try their luck with these stocks. But if most brokers advise you to steer clear of pink sheets and OTC shares, why do they exist?
Penny stocks are still a thing because of the freedom of pricing. The SEC views any stock under $5 as a penny stock and can’t punish a company for its stock price falling below $5. While this makes penny stocks perfectly legal, it doesn’t make them great long-term investments.
In this article, you will learn why penny stocks are a notorious investment and what threats to look out for when investing. You will also learn how to profit from them if you are willing to buy these shares.
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 Is a Penny Stock?
To understand penny stock trading, you must know what they are. People often assume the name refers to stocks that sell for a penny each. That is rarely the case.
Penny stocks are usually worth less than $5 but more than a penny. They are generally traded on over-the-counter markets (OTC). Electronic listings such as the Over-The-Counter Bulletin Board (OTCBB) and Pink sheets are the main markets for penny stocks to thrive in.
Companies issue these stocks with low market capitalizations and low revenue streams, and a lot of the time, these companies will have shaky future prospects and a high risk of shutting down.
Penny Stocks and Their Risks
You may ask yourself, what is so terrible about investing in a penny stock? Is it that risky? The answer is yes. But where there’s a risk, there is a possibility of a reward. Below are some risks that you should watch out for when trading penny stocks.
Penny Stocks Are Not Usually Sold on Large Stock Exchanges
You may find a few penny stocks on the New York Stock Exchange (NYSE) or NASDAQ, but do not get your hopes up. These stock exchanges come with a list of requirements that must be met for a company’s shares to be sold.
These companies are dependable because they are regulated. We’re not saying you won’t find a share below $5 on the NYSE, but the companies behind them will have a proven track record of profits or equity, making them steady enough to sell. That being said, this is not the case with most penny stocks.
OTCBB and Pink Sheets quote prices electronically, and neither do they have any strict listing requirements to meet. Meaning, a start-up company with very little capital can issue shares here with nothing and no one to back up their profitability.
Penny Stock Prices Are Highly Volatile
All shares are subject to fluctuations; investors look forward to seeing the prices of shares they hold rise and watch in apprehension in case they fall. With penny stocks, volatility is higher than usual, meaning they are more unpredictable than your average stock.
People are unwilling to invest in penny stocks and those who do tend to stock up on the shares. These large transactions on shares that cost mere cents make the prices fluctuate in a higher proportion, distorting their prices and making them unstable.
Scammers
Speaking of price distortions, you need to know that OTC listings are crawling with scammers. Schemes such as pump-and-dump or short and distort are not challenging to find. Often, scammers cause price distortions because they spread rumors and false promises of profits on stocks they hold through advertisement schemes. Once the prices rise, they sell these stocks, keeping the profits and leaving investors with worthless stocks.
False Advertising
If you have seen The Wolf of Wall Street, you must remember the scene where Jordan Belfort sells penny stocks for Aerotyne. He labels them as a cutting-edge, high-tech firm with tremendous upside potential and minimal downside risk when, in reality, it is run by a few brothers who work in their garage. This is the scale of penny stock advertisement; they promise high returns for companies that barely have enough profits to cover their costs.
Penny stocks have low liquidity. Usually, shares are highly liquid; people who trade on the stock exchange buy and sell shares daily to make profits. Penny stocks have very few investors. Most of them are either beginner investors attracted to the low investment cost and under the illusion of success stories they heard about penny stocks or investors who have been around in this market for very long and know how to tackle this market.
Either way, your audience to sell is limited. Even if you do buy a low-cost share and wait for the price to rise to make a profit, chances are you may not even find a buyer that soon. Given how much prices fluctuate, the price may drop before you even come around to sell them.
Why Do Penny Stocks Exist?
Regardless of the numerous risks that come with penny stocks, they exist to this day because it is possible to profit. Yes, it isn’t easy, but investors have made large profits in these stocks. Plus, all scammers aside, some companies on Pink Sheets are actual start-up companies with real potential looking for investors to expand operations. What you need to know is how to make a profit with penny stocks.
Research
Penny stocks companies have very little information available about them. Depend on authentic sources and find financial records to study their earnings. Try to work with penny stocks that sell 100,000 shares per day and companies operating in an industry that promises growth.
Stock prices are also crucial in assessing a stock; just because they sell for 40 cents does not mean they have growth potential. In fact, these are the firms with low market capitalization, so do not fall for low prices. Information about companies is usually available on the SEC website or the company’s website. Not finding any information is a red flag.
Create a Diverse Portfolio
Make sure you set aside a specific portion of your money for penny stock investment. Give yourself a budget and stick to it. Invest the rest of your money in different, more profitable types of stocks.
This will reduce overall potential risk, and if you can endure a high risk, your budget can be higher, although a few professionals recommend putting no more than 10% of your income on penny stocks.
Avoid Extra Costs
Penny stocks already do not ensure profits, so cutting down transactional costs associated with them is essential. Avoid broker fees. Try to find a broker who does not charge a commission per share and instead has a flat rate.
Avoid Scams
Stay on the lookout for pump and dump schemes. Study the prices of a stock for a week for excessive fluctuations, especially in terms of volume. If it shows consistency, invest in it. Also, do not fall for intense advertisements with empty promises.
Low Stock Prices Do Not Equal Potential
A good rule here is to buy stocks priced above 50 cents. A stock priced lower than that may seem fishy, and if no background is available on the company, it is probably a scam. Be realistic. Know that penny stocks promise a very low profitability rate. The chances of losing your investment are higher than making a return.
Author’s Recommendations: Top Trading and Investment Resources To Consider
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Conclusion
Penny stocks exist because it is still possible to make a return on them. Companies with solid stock and returns can always be found if you follow the advice listed above. However, we would suggest not to get your hopes up; not everyone has money to burn on penny stocks. But if you enjoy the thrill and have a high-risk tolerance, you may come out successful.
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!
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