Penny Stocks – The Risks and Rewards

Penny Stocks Risks and Rewards

Penny stocks are known for being high-risk investments that have the potential to quickly produce large gains. The appeal of buying many shares with a small amount of cash attracts many beginner traders. And owning more shares allows for more profits if the share price does increase. However, buying penny stocks is more similar to playing roulette at a casino than it is investing. Those that are successful trading penny stocks take the time to sufficiently research the companies and effectively manage risk. 

In this article, we will clarify what a penny stock is, how to trade them and the potential risks involved. 

What are penny stocks?

Generally, any stock that trades below $5 is defined as a “Penny stock.” This classification comes from the United States Financial Industry Regulatory Authority (FINRA) and the United States Securities and Exchange Commission (SEC). However, many believe a true penny stock is one that trades under a dollar and above one cent. That right, some can trade for fractions of a cent. While some penny stocks are available on exchanges, most are offered through over-the-counter markets, sometimes referred to as “pink sheets.” The low share price that comes with penny stocks is accompanied by low market capitalization. The majority of them are micro-cap stocks. The companies trading in penny stock territory are typically new, very small, in an exorbitant amount of debt, or heading towards bankruptcy.

Over-the-counter markets (OTC) and (OTCBB)

As mentioned earlier, the bulk of penny stocks are traded through over-the-counter markets. The Over-the-Counter Bulletin Board (OTCBB) is a U.S. quotation source used by companies that are not listed on a national stock exchange. Brokerages that subscribe to OTCBB allow investors to purchase and sell OTC securities. Securities that have been “de-listed” for failing to meet the requirements set by the SEC usually end up on the OTCBB. OTCBB and OTC markets have no minimum requirements to stay listed. The OTCBB does not encompass every quote, some are only available through Over-the-Counter Markets or “Pink Sheets.”

Stocks traded in the Pink Sheets or OTCBB are typically avoided due to fear of fraud and manipulation. You will find companies that are quoted through both OTCBB and OTC. You can usually find a suffix of “OB” that refers to the “OTCBB” and “PK” referring to “Pink Sheet” next to the stock ticker. Investing in over-the-counter stocks comes with even more risks due to less strenuous regulation.

Major exchanges

Securities that are listed on the NASDAQ and New York Stock Exchange (NYSE) are subject to more regulation. They have minimum requirements for market cap, share price, number of shareholders and must disclose additional information. Not all brokers handle OTC and those that do usually require additional fees. Penny stocks listed on major exchanges are available through the majority of brokerages. It’s easier to find information about companies that are listed on an exchange. They also offer better liquidity than OTC and there is less risk of manipulation or fraud. You will find a larger variety of penny stocks through over-the-counter markets but they’re also subject to more volatility and risk. At the time of this writing, there are around 1,000 stocks with a share price lower than $5 listed on the NASDAQ and NYSE.

The risks of penny stocks

Scammers will purposely misinform those with less experience, enticing them to invest in worthless or fraudulent companies. Anyone looking to trade or invest in penny stocks must be extra careful to avoid getting deceived. There are many risks associated with penny stocks, some of which we have already brushed on, like lack of information and low liquidity. Below, are some examples of common scams you should avoid.

Manipulation

Professional investors with a large amount of capital can easily affect the price of penny stocks. The price can be manipulated by simply buying or selling a great deal of shares. Since micro-cap stocks have such small market capitalization, it makes it easy for “whales” to manipulate the price.  

Pump and dumps

One of the most common scams that involves artificially inflating a stock price through disinformation and fabricated hype. “Promoters” spread fake information and bring attention to an unknown stock to convince investors to buy it. The pump propaganda is spread through social media, e-mail newsletters, online forums, and other means. The key to a pump and dump is to buy while the share price is low, get others to buy it to make the price go up and then sell it. This leaves investors with a large loss with little to no chance of the share price ever recovering. 

Stock promoters

Stock Promoter Night Singer of Shares
The “night singer of shares” sold stock on the streets during the South Sea Bubble. Amsterdam, 1720.

The main goal of a stock promoter is to persuade others into buying shares of a stock they’re promoting. They’ll use fraudulent or shady tactics that are mostly illegal in order to achieve their goal. Since there’s little information available on the companies listed on OTCBB or OTC markets, they are heavily targeted by “stock promoters.” Without any publicly available financial information, it’s difficult to fact check the false claims made by stock promoters. Always be wary of any information that promises to make you rich from buying a penny stock.

Other scams

The short-and-distort scam is the opposite of a pump and dump. Promoters spread fear or FUD causing a stock to dump while those who are shorting the stock profit. Offshore scams involve scammers outside the U.S that purchase shares at a discount and then re-sell them at a higher price. Telemarketing and cold calls from salespeople convincing others to purchase scummy micro-cap stocks used to be a very popular scam before the internet. It’s still possible to get cold calls from strangers that will try to fool you into buying penny stocks for their own benefit. Additional scams to be aware of are the “bait-and-switch” and “no-net-sales” schemes where victims are prohibited from selling the stocks they were tricked into buying.

Reducing risk

The fraud, scams, and manipulation within the stock market are not exclusive to just penny stocks. But it is more rampant among micro-cap companies. The most effective way to reduce the risks that come with penny stocks is to avoid them completely. Most professional investors will strongly advise against trading penny stocks. And many new traders get wrecked after buying them. Just like any other investment, there are methods that can help to limit risk. Below is a list of tips and different ways that can reduce the risks of investing in penny stocks. 

  • Do extensive research before buying
  • Learn to spot false information and ignore stock promoters
  • Read the fine print and disclosures on all important information 
  • Trade with funds you can afford to lose 
  • The more information available on a company the better
  • Less information means more speculation
  • Always use a trading plan 
  • Stocks traded through OTC markets are riskier than those traded on major exchanges
  • Never follow a “hot tip”
  • Use a stop-loss

The rewards of penny stocks

After covering all of the sketchy dealings, risks, and scams that can accompany penny stocks you’re probably wondering why anyone would invest in them. Well, one of the appeals discussed at the beginning of the article is the ability to purchase a multitude of shares with a small amount of money. The potential to lose a lot of money means there’s also potential to make a lot of it. Penny stocks can frequently see returns of 1000% or more. There is also the chance of getting in at the beginning of the next big thing. Although there are many who go bust with penny stocks, some have been made into millionaires. The same thing can be said about lottery tickets, so don’t let the rewards cloud your judgment.

How to trade penny stocks

Once you understand the risks and know how to avoid the scams, let’s discuss how you can start trading penny stocks. You’ll first want to determine if you are going to buy penny stocks that trade on OTCBB or OTC markets. Over-the-counter markets splits its securities into 3 groups: OTCQX (highest quality), OTCQB (middle quality) and OTC Pink (lowest quality). The quality is based on the amount of disclosure, honesty of company processes, and its interaction with investors. After you’ve decided between NASDAQ/NYSE or OTC penny stocks and have picked a broker to use, follow the steps below to help increase your chances of success. 

5 trading steps

  1. Determine the amount you will be purchasing.  Don’t go overboard and don’t bet your entire portfolio. Set a limited amount that is appropriate to your risk appetite. Using 3% or 5% of your portfolio is recommended while 10%-15% should be a maximum. This leaves you with some protection and the ability to put a cap on losses. 
  2. Evaluate the stock, and pick one that you believe has upside potential. You want to get a return that is worthwhile and limit any possible losses. This will take some homework and research on your end.  Analyze the company, the charts, sentiment, and trends. Again, cut out any noise from stock promoters and be cautious. 
  3. Make sure there is sufficient trading volume and liquidity. You will want to be able to sale and realize any profits. It’s best to stick with stocks that trade around 100,000 shares a day. It’s very important to pick stocks with good volume otherwise you can end up getting stuck.
  4. Know when to sell. Trading penny stocks is a short-term strategy. You will need to stay alert and be prepared to react quickly to any changes in share price. Most people that are successful trading penny stocks are day traders. It’s very rare for penny stocks to become good long-term investments. Plan on what level at which you will take profit or set a stop-loss. 
  5. It’s better to stick with the best and trade higher-quality companies. You’ll usually have higher success trading stocks that are breaking 52-week highs instead of making new lows. Follow the trend and weed out any pump and dumps. 

Bottom line

Due diligence is even more important when it comes to penny stocks. You really must take your time examining the company and charts before investing. If you are okay with taking on risky investments and can appropriately manage risk, then penny stocks may be for you. If not then steer clear and stick with established companies or index funds. Despite the potential for big rewards, penny stocks have earned their rough reputation, so be careful.