Perhaps you’ve heard the legend. Apple Inc. once traded as a penny stock. Yes, that Apple. The one behind the iMac, iPad, iTunes, iEverything; the Apple that currently has the largest market cap in the world.
Taking stock splits into account, at one time you could have bought in for less than a dollar per share. That’s right, if you were alive and a savvy investor in 1982, you could have bought shares in Apple for $0.23 each. Even as late as 2004 it was trading below a dollar.
Had you bought even a modest position at either of those prices, you’d now be a millionaire many times over. This is the allure of the penny stock. Find a dirt cheap up-and-comer and one day you’ll be wealthy beyond your wildest dreams.
Unfortunately, for every Apple Inc. there’s a million penny stocks you’ve never heard of because they didn’t make it.
As it turns out, Apples don’t grow on trees.
But the truth is that you don’t have to find the next Apple to make money trading penny stocks. Although there is significant risk involved, trading penny stocks can prove quite profitable to knowledgable traders over the long run.
What is a penny stock?
A prototypical penny stock is cheap, small in terms of market capitalization, volatile, lightly traded, and risky.
How cheap is “cheap”? There’s some argument over that minor detail. Traditional penny stocks are any stocks that trade for less than a dollar a share (hence the name) but over time the definition has broadened quite a bit.
Nowadays many traders consider any company trading under $5 a share to be a penny stock as long as its market cap is less than $300 million.
I think it’s a little pedantic to put an exact price or market cap on a stock before categorizing it as a penny stock. A better way to define penny stocks is to look at the characteristics they have in common.
Penny stocks are small companies trading on the cheap. Most suffer from a lack of liquidity, meaning they are not frequently traded and many are not listed on a major exchange and must be purchased over the counter. Penny stocks are also often characterized by dramatic price swings on a percentage basis. All of these factors also increase the risk associated with trading penny stocks.
Cheap, small, volatile, lightly traded, and risky – that’s a penny stock, even if it’s trading at $5.01 per share.
Advantages of trading penny stocks
So why would anyone want to invest in something cheap, small, volatile, lightly traded, and risky? There are some great advantages to trading penny stocks rather than just scouring major stock exchanges like the New York Stock Exchange for the big names that everyone knows.
The biggest advantage of investing in penny stocks is, of course, how affordable they are. You can gobble up way more shares of a penny stock than you can of say, Amazon, which is currently trading at well over $3,000 a share.
You can make money trading stocks like Amazon, but your returns could be far higher in penny stocks since you can take a sizable position in a company with very little cash.
Since a penny stock has, by definition, a small market capitalization, you can affordably own a much larger portion of the company than you ever could with a blue chip stock.
That means a much larger portion of company profits — if you have the patience to stick around long enough to see any profits and if there are actually profits to stick around for.
Smaller companies also have a smaller float, which means more dramatic price swings.
Invest in penny stocks long enough and you will see some insane price movements, in either direction. Penny stocks are far more volatile than their more established stock market cousins. Stocks doubling or halving their values on a single day are not uncommon.
This is especially true of penny stocks that trade OTC (over the counter) rather than on the New York Stock Exchange, NASDAQ, or other major market exchanges. One reason is that companies that trade in OTC markets are way less regulated and less documented. It can be very difficult to discern the actual financial standing or prospects of OTC penny stocks. When actual news hits that sheds some light on the company’s financial position or potential future earnings, it can send a stock soaring (or plummeting).
Another reason for increased volatility amongst penny stocks is illiquidity, which I’ll cover more in the Disadvantages section, but volatility can be a great advantage to the right investor.
Volatility means a stock is either very rapidly rising or falling in price. If you can identify which direction a stock is going or will continue to go, you can profit off that movement by either buying long or selling short. If the stock moves in the direction you anticipated and does so as rapidly as many penny stocks move, you can make a great deal of money in a very short time frame.
The trick, of course, is mastering the ability to anticipate a stock’s movement. That’s no easy task.
Low trading volume
With so many new traders entering the market for penny stocks, this isn’t the advantage that it once was, but for a long time, lightly-traded also meant overlooked.
If you believe in buying penny stocks for their long-term potential, which is a difficult undertaking, a stock that flies under everyone else’s radar is exactly what you’re looking for.
Risk can be an advantage for those who have the means or the constitution to take on riskier positions. After all, the greater the risk, the greater the reward.
If penny stocks were safe, they’d be less affordable, meaning they would no longer be penny stocks. The high risk is a big factor in why they are so cheap.
It’s also notable that among the more risky investment strategies, trading penny stocks is comparatively safe. If you are considering futures or derivatives trading, for example, penny stocks might be a safer bet. Unless you’re borrowing money or buying on margin, you can only lose what you put in, which is not the case with other, more complex financial instruments.
Disadvantages of trading penny stocks
Wouldn’t you know it, all the advantages of trading penny stocks are also the disadvantages. This is why so many people have a love/hate relationship with penny stocks.
The same advantages that can make you a great deal of money can also be the disadvantages that cost you the farm.
Penny stocks are cheap for a reason, friends. We live in an era of very efficient markets which means that most securities are pretty accurately priced. As a penny stock trader your job is to find the anomalies which aren’t easy to spot.
Penny stock companies trade cheaply because of any one of a number of factors. They may be young companies without substantial financial records or with unproven management, or maybe they’re experimenting with new technologies that may or may not catch on.
Other possibilities are that they’re older companies that are flirting with bankruptcy and on very shaky financial footing. Or maybe there is just very little public information available which makes them extremely risky. There’s also the possibility that the trading in that stock had once been suspended by the Securities and Exchange Commission (SEC) due to suspicious activities.
When you trade penny stocks, just remember that a stock price is the reflection of investors’ opinions of that stock. Penny stock prices speak for themselves.
Always ask yourself why exactly is this stock so cheap before you pull the trigger on any penny stocks trade.
Most penny stocks are often traded over the counter, which means they are not subject to typical reporting requirements like a larger company listed on a major stock exchange would be. This lack of information is a real problem when you’re trying to forecast a company’s future earnings.
A company’s market cap also comes into play when considering how well the company can weather a storm. Penny stock companies often do not have the financial resources to bail themselves out in the event of a poor product launch or a general economic slump. This is another reason so many penny stocks collapse. They are definitely not “too big to fail.”
While most traders who invest in penny stocks try to take advantage of high volatility, it can obviously be a serious detriment. You can lose a lot of money in the blink of an eye. It takes a lot of focus to trade penny stocks because if you look away for a moment all could be lost.
It’s also important to contemplate why penny stocks are so volatile. Lack of information is a big reason — when a company is shrouded in mystery, news of any kind has a dramatic effect on its price. This becomes a problem when the news in question comes from dubious sources or when misinformation is purposely circulated in order to drive up a stock price.
Indeed, scams taking advantage of a lack of information and volatility are big land mines in the world of penny stock trading. Probably the most famous are pump and dump schemes in which the perpetrators buy significant positions in a penny stock and then step into the information void surrounding the company and circulate false news about the company.
They “pump” the stock by trumpeting this news to as many investors as they can, which drives share prices up significantly. Then they dump the stock before everyone catches on that the news item was ‘fake’. The stock then plummets, costing all the new investors a pretty penny.
Another main reason for the volatility of penny stocks is illiquidity which I’ll talk about below.
Low trading volume
A penny stock that is not heavily traded can lead to real problems should you want to sell off a position or buy in at a low price. With many penny stocks, it can be really difficult to find a seller or buyer on the other end of your transaction. This means you may have to settle for a price that’s not as favorable as anticipated in order to coax a buyer out of the woodwork.
Illiquidity also often means brokers may charge higher commissions in order to complete your trade. If you are day trading penny stocks and making multiple transactions in a single day, higher commissions can really eat into your bottom line.Risk
If you don’t have a high risk tolerance or if you’re investing money that you can’t afford to lose, it is probably best to seek out less risky investment vehicles.
For all the reasons that I mentioned above, penny stocks are risky. A lot of penny stock investors repeat “high risk, high reward” like a mantra and you hear it so many times it can become easy to focus on the last part without truly contemplating the first part. High risk, means high risk! That means that the high reward is not particularly likely.
If you want to trade penny stocks, always keep that in mind. Understand that while rewards can be great, your odds of success are not good.
Penny stock scams and regulation
For many years, there was very little regulation when it came to penny stocks. The movie “Wolf of Wall Street” famously (and fairly accurately) shows Jordan Belfort’s manipulation of the “pink sheets” or OTC penny stocks.
Belfort’s brokerage firm, Stratton Oakmont, made hundreds of millions of dollars off penny stocks, often by using the “pump and dump” strategy to defraud investors or by simply charging ridiculous commissions to execute penny stock trades.
Traders like Belfort exploited the deficiencies in the penny stock market so outrageously that regulators couldn’t help but notice. Belfort went to jail, Stratton Oakmont was shut down, and new laws were enacted to make the markets safer for would-be investors.
The new regulatory push certainly helped legitimize the penny stock market, but that’s not to say they eliminated all frauds and scam artists.
The opaque nature of penny stocks and the possibility of rapid returns means that there will always be people out there trying to take advantage of gullible investors. If you hear about a hot penny stock, always question the source of the tip, and what they may have to gain.
Is it a broker trying to push you into a position to make extra commissions? Or are stock promoters just trying to pump up their stock before they dump? Make sure you understand their motivation before you act, and avoid penny stocks that are overhyped without good reason.
In general, never buy penny stocks without doing your own research and always beware of lists touting the “best penny stocks” or sub penny stocks. Unless the list comes from a very trusted source, it is probably being circulated by people looking out for their own interests rather than yours.
You can also protect yourself by researching your investment advisor on the SEC’s Investment Advisor Public Disclosure database which can alert you to any shady operators.
At the very least, make sure your broker or advisor follows all the rules for penny stock brokers as laid out by the Financial Industry Regulatory Authority.
Strategies for trading penny stocks
People either love or hate penny stock trading. There doesn’t seem to be any in-between. Of course, if you dig a little deeper, the haters almost always seem to have fallen victim to a pump and dump scheme or they’ve tried to trade penny stocks without a defined strategy.
If you’re just messing around with penny stocks because they’re cheap, you certainly won’t get rich and you’ll probably lose money, but if you approach the market with realistic expectations, do significant research, and use a set strategy, you can greatly improve your chances of success.
Everyone has their own strategies for trading penny stocks, of course, and I strongly suggest you develop your own approach and practice using it through a trading simulator.
My strategies for trading penny stocks can roughly be broken down into these two categories:
Diamond in the rough
I have to admit, this is my favorite strategy for trading penny stocks, even though it has barely netted me a dime in all my years investing. I love looking through penny stock companies, doing a little bit of research, and trying to find the next Apple.
I’m realistic about my odds of success (slim to none) and I certainly don’t devote a large portion of my portfolio to it, but it might be the most enjoyable investing I do. I could almost classify it as a hobby.
There’s something about rooting for the long shot and potentially being in on the ground floor of a company that might change the world that I really love; even if I lose more often than I win. Only penny stocks offer that sort of rush.
In some ways, the diamond in the rough strategy was easier to implement not so long ago. Now, with the rise of retail investing, even the most obscure stock, from the pinkest of the pink sheets, has been looked over by a lot of eyes. Millions of traders mean millions of diamond miners.
That means if a company is still cheap, it is probably cheap for a reason and a bunch of investors just like you looked over the same info you’re looking over and decided to pass. So you have to be right when a million other investors were wrong. That should definitely give you pause, but in a way, it adds to the appeal.
I never risk more than I can afford to lose on this strategy and I’ve watched many would-be diamonds turn out to be fugazis. It’s not a strategy I would ever depend on, but it’s also not a strategy I would ever give up.
I’m lumping some varying strategies under this broader umbrella, but most traders who make money buying penny stocks do so by taking advantage of the inherent volatility in penny stocks and holding their positions for a very short time frame.
Using technical analysis or various stock screening techniques, successful traders can quickly identify penny stocks that are beginning what they hope will be a sizable run. Then they buy long and get out early before the stock plummets to earth.
They are making money the same way the pump and dump scammers do, only they are doing it legitimately. That means they have to find penny stocks that are going to make a run and then time that run perfectly without manipulating the market.
Day trading penny stocks in this manner can be very lucrative providing you can properly identify companies who are going to move, then get in quickly, and also perfectly time your exit to maximize profits without jeopardizing your gains.
You also need a lot of discipline to trade penny stocks successfully. Penny stocks can go up ten-fold in a single trading session, but cautious investors are probably out of the stock well before it hits its high. Why? Because you never know when it will come crashing down to earth.
That means taking out your gains early and erring on the safe side. You’ll leave a lot of money on the table when a stock makes one of those breathtaking runs that penny stocks are famous for, but you won’t be caught desperately trying to unload your position when the stock heads south.
Since penny stocks are so illiquid, momentum trading takes a lot of precision. If you are late to exit and try to make your transaction after the frenzy is over, you may have a very difficult time selling your shares at an attractive price point.
How to start trading penny stocks
Gaining access to the penny stock world is pretty easy. Whether you want to buy penny stocks that trade on the NASDAQ or trade over the counter, you can do so with a simple, online brokerage account.
Investing in penny stocks is that simple. In comparison to other investment opportunities with similar risk profiles such as futures or options, it is very easy to start buying penny stocks. You just need to select a broker, fund the account, and get started.
Choosing which brokerage to use can be difficult because there are so many options, so I’ll be publishing a list of my favorites soon. In the meantime, take the following factors under advisement when making your choice:
Make sure you know how much your broker is charging you per trade. If you plan on day trading, this will be of particular importance. High commissions can erode much of a day’s earnings if you’re not careful.
High commissions can also influence your trading strategy. If you’re hesitant to buy or sell penny stocks because of the high commissions, you probably won’t be as nimble as you need to be.
Also be aware that some brokerages have hidden fees. Make sure you know exactly what they’ll be charging you.
- Trading platforms
Many brokerages allow you to test out their trading software and make simulated trades. I strongly encourage you to do so, just to make sure you are comfortable with the trading platform.
Also consider whether or not you will be trading via your home desktop or if you’ll be trading on the go through your phone or tablet. For a lot of brokerages, their mobile trading platform is a little different from what you’d use on your desktop, so make sure you are comfortable with both.
- Trader support
Brokerages support their traders in a lot of ways. The better brokerages offer a lot of educational programs that can broaden your horizons and help you become a better, more disciplined trader.
Some brokerages also support their traders by providing access to their research department and providing other resources that will allow you to streamline your research process and make sure you are getting the best possible information. Good research can be invaluable in helping you find penny stocks before they move.
You should also try to determine the quality and efficiency of their customer service department. Should you encounter a problem, how quickly will someone get back to you? Will you be stuck waiting on hold over a technical glitch while the stock of your dreams slips through your fingers?
Check online reviews and read about the experiences of other traders when they encountered problems. How quickly and efficiently did their broker respond?
- Regulatory compliance
If you are just looking at the larger, more prominent brokerages, you don’t have to be so concerned about this, but if, for whatever reason, you are looking at more obscure brokerage houses, you need to make sure that they are following the rules.
As I mentioned earlier, make sure they are compliant with the Financial Industry Regulatory Authority and if you are trading based on an advisor’s picks, double check with the SEC’s Investment Advisor Public Disclosure database that your advisor hasn’t run into trouble in the past.
You wouldn’t just hand your wallet to someone you don’t trust. That’s essentially what you are doing when you open a brokerage account. So make sure you have a broker you can trust.