Traditional wisdom for casual retail investors is to avoid penny stocks. The rationale is straightforward: Penny stock markets can be like the back alley in the investing world. Fraud and manipulation are not uncommon, and scams known as “pump and dumps” have affected many retail investors.
The Securities and Exchange Commission says many of these companies do not file any financial reports with the agency, so getting accurate information can be difficult.
However, investors trade billions of dollars every day in such markets, and there are plenty of opportunities for savvy investors to make money with penny stocks. Every once in a while, you might find a gem of an opportunity. It’s not impossible to see a 100% return or more on a penny stock, which is the primary reason people trade them.
Keep reading to learn how to be successful in trading penny stocks.
What Are Penny Stocks?
Penny stocks are not just stocks that trade for pennies. There isn’t an official definition of a penny stock, though they are generally stocks trading under $5 per share. Prices can go all the way down to $0.0001 per share.
Penny stocks are in the category of securities known as microcaps. These companies are generally small, with low stock prices and low market capitalization. The SEC definition of a microcap is a company with a market capitalization of less than $300 million.
According to the SEC, the primary difference between penny stocks and other stocks is the company’s lack of public information. Unlike large public companies that file regular reports with the SEC, many penny stock companies do not make their financials public.
Are Penny Stocks Legitimate?
Companies that are considered penny stocks aren’t necessarily terrible or illegitimate. But know that there are some penny stock companies engaged in fraud. Others may also be on the verge of bankruptcy.
But many good companies can trade shares at prices considered penny stocks. Many startups start with low valuations and low share prices but can grow quickly. Others may be experiencing temporary problems that time or new management can solve, and the stock will recoup its former price.
The global pandemic has impacted many good companies with supply or demand problems. Some have already started to recover. For example, Ford Motor Co. stock was trading under $5 in April 2020. A year later, the stock saw prices exceeding $13 per share.
What Is an Over-the-Counter Market?
Investors trade penny stocks in “over-the-counter” markets. That means you won’t find penny stocks on large exchanges like the Nasdaq or the New York Stock Exchange.
FINRA, the financial markets regulator in the U.S., oversees all financial markets, including penny stock markets. FINRA oversees two systems that provide quotes for OTC markets: OTC Bulletin Board and OTC Link LLC.
OTC Markets Group Inc. also operates the OTCQX Best Market, the OTCQB Venture Market and the Pink Open Market for over 11,000 U.S. and global securities, many of which are penny stocks.
Investing vs. Speculating
Knowing the difference between investing and speculating is essential for penny stock traders. Your mindset going in is half the battle in setting yourself up for success trading in this market. If you approach the penny stock market the way you would the regular stock market, you might not find success. It’s a different animal entirely.
Investing is when a person allocates capital with the hope of earning a profit over time. Investors try to find opportunities with relatively low risk that have a good chance of generating profits. Often, the time horizon is very long, especially if you’re talking about investing for retirement.
Conventional wisdom advises that you invest in good businesses with good management and stay invested for the long term. According to Forbes, the average return of large-cap stocks from 1926 to 2018 was 11.9%.
Penny stocks, on the other hand, are much more volatile. You could earn 100% or more, or you might lose your entire investment. Speculating is different from investing because traders seek unusually high returns from trades with very high risk. This risk is why experts say you shouldn’t put too much of your portfolio into any single penny stock trade.
How To Be Successful With Penny Stocks
With the extreme risk, occasions of fraud and lack of public information, you might be wondering if anyone can be successful trading penny stocks. As with all kinds of trading, the short answer is maybe. Many people lose money trading penny stocks, but there are ways to minimize your risks.
Don’t Risk Money You Can’t Afford To Lose
If you’re just beginning, this is probably the first thing to internalize. You can generate extreme profits, but you’re also taking extreme risks. Therefore, never trade with money that you can’t afford to lose.
Don’t trade with money that you need to pay for your usual expenses. You could lose it all. Only trade extra money that you don’t need to live. There’s not much that is more stressful than losing money that you need to pay your bills.
Start Small and Diversify
Conventional wisdom advises you to diversify your portfolio to minimize risk. Don’t go all-in with penny stocks, let alone a single penny stock trade.
Try to allocate only a small percentage of your overall portfolio to penny stocks. You might turn 1% of your portfolio into 10%. But if you lose that 1%, you can recover from the loss.
Avoid Scams and Red Flags
Because penny stocks are traded OTC, they don’t have the same reporting requirements as bigger companies do. This creates an environment ripe for fraud and manipulation. There are many websites and newsletters that advertise fraudulent penny stocks.
Some fraudsters engage in pump-and-dump campaigns where they buy a stock at a low price and then convince others to buy the stock. They may advertise promises about the company’s future gains to pump up the company.
When people start buying, the price goes up. At some point, the fraudsters dump their shares on the unsuspecting investors, which causes the price to drop significantly. Investors that bought in during the pump are left holding the bag.
Do Your Research
While some penny stock companies don’t make their information public, many do. OTC Markets provides investors with quotes, company profiles, security details, news, financials and reports for over-the-counter stocks. Here are just a few elements to investigate:
- Reporting status: Is the company reporting its financials or is it behind?
- Market cap: What is the value of the company, measured by market cap?
- Outstanding shares: How many shares are on the market for trading? This data can guide you on how large of a position to take.
- Financials: Is the company profitable or not? What are its revenues and expenses? This data gives you indicators about how valuable the company is.
- News: Are there recent press releases or news articles about the company?
- Volume: How many shares are trading every day? This data gives you an idea of how liquid the stock is, which is vital for getting out of your position when you want.
Take Your Profits
Remember that you aren’t investing in penny stocks for the long term. Just because your trade saw a 30% gain on paper doesn’t mean that it’ll go to 100% or higher. It’s never a bad idea to go ahead and take any profits you see. Your 30% gain today might be a 10% loss tomorrow. That’s how volatile penny stock trading is.
One idea is to sell enough shares to get back the original investment, leaving the rest to generate additional profits if the stock continues to rise.
Use a Penny Stock-Friendly Broker
Picking the right broker is essential for success with penny stock trading. Many brokers today advertise $0 commissions, but they may charge for over-the-counter trades. For example, E-Trade charges a $6.95 commission per trade of OTC stocks. Other brokers charge a surcharge on transactions of stocks under a specific dollar amount.
Good To Know
Brokers may also have volume restrictions, which is essential to know when trading penny stocks. For example, spending $1,000 on a stock priced at $0.01 means you will buy 100,000 shares. You want to know that you can buy and sell the number of shares that you want.
Penny stock trading offers the potential for huge gains. But that opportunity comes at the risk of losing it all. Trading over-the-counter stocks can be a wild, emotional ride. But you can take a few small steps to limit your risk and maximize the chances for success in this market:
- Don’t trade with money you can’t afford to lose.
- Start small and diversify your holdings.
- Do your research and avoid the hype.
- Take your profits and keep trading another day.
Jared Nigro contributed to the reporting for this article.