Amazon and Tesla lack the volatility of penny stocks, which frequently get a bad reputation due to incomplete information and susceptibility to scammers.
Are penny stocks worth it? It's very tempting to dabble in penny stock trading since positions frequently double overnight (or quicker), but there are quite a few drawbacks to consider. Penny stock trading isn't for everyone. Those who partake need a strong risk appetite, technical charting skills and the ability to stick with a strategy even when the price exceeds your expectations.
What are penny stocks?
Penny stocks are an ill-defined cohort of equities. Some definitions include any stock under $5 per share. Others limit the share price to $1, and still others consider the market cap more than the actual share price. But for this article, we'll use the Securities and Exchange Commission's (SEC) definition: an illiquid stock trading for below $5 per share.
A penny stock is often a troubled company. With a low market cap and limited share count, these companies often struggle financially or have questionable management and motives. Investing in penny stocks will always be a gamble since there are far more losers than winners in this market area. You'll need to develop a plan with strict risk management controls to trade penny stocks.
The appeal of penny stocks
Why would a diligent investor want to invest money in a troubled or sketchy company? The same reason anyone enters the stock market - to make money! But penny stock investors aren’t looking to preserve wealth over time. They want quick profits, meteoric gains or some combination of both.
Penny stocks are some of the most volatile securities available because they have small market caps, low share floats and can easily be influenced by a small number of buyers. Since a relatively small amount of capital can have a massive influence on a penny stock’s price, it’s not rare to see gains of 50%, 100% or even 200% in a single day. When gains like this occur frequently, risk-seeking investors are tempted to dabble, even if the odds of these companies ever being successful are long.
Risks of penny stocks
Any legitimate penny stock strategy requires investors to know the risks of these types of securities. Penny stocks don't trade in the depths of the market because they have been mistreated — most have legitimate problems.
Here are a few risks to be conscious of when investing in penny stocks:
Risk 1: High volatility
Extreme volatility is the siren penny stock song for many traders looking to make quick profits, but most market participants won't have the stomach for these price swings. Penny stocks can double or be cut in half in a single trading day, so traders must monitor their positions minute by minute. If you don't have time to stare at stock charts all session long, penny stocks aren't for you.
Risk 2: Minimal public financial data
Companies that trade on major U.S. exchanges like the NYSE and NASDAQ have strict requirements for reporting financial data. Quarterly earnings reports aren't something companies do out of the kindness of their heart — federal authorities mandate them. Many penny stocks trade over the counter through broker-dealer networks and aren't subject to these requirements. Accurate financial data on these stocks can be hard to find, and transparency is frequently lacking.
Risk 3: Easily manipulated by scammers
Penny stocks don't just have low share prices; they also have low market caps and trading volume. A stock with a low share price can still have plenty of volume but the combination of low prices, market cap and share float attract scammers like picnic baskets attract Yogi Bear. Be cautious of any stock picker claiming they've found the next Amazon or Tesla — they're likely trying to dump their illiquid shares on you as they exit the stock.
Risk 4: High-risk companies
Penny stock companies aren't plucky underdogs looking for a big break. Most of them are trading for pennies because they have questionable accounting practices, poor management, or have long-shot odds of getting their product to market. For example, you can find small biotech companies making drugs with limited hope for successful trials in the penny stock arena.
How to evaluate penny stocks
The primary goal of any penny stock trader should be to avoid scams like pump-and-dump schemes. Since these shares are often lightly traded and illiquid, a large buy or two can skyrocket the price. Scammers know this and attempt to pump the price up with a few timely purchases and then dump their holdings on unsuspecting retail traders. Here are a few ways to keep yourself out of penny stock scams.
Research
Finding legitimate financial information on penny stock companies can be like searching for water in a desert. Companies trading on OTC markets don't have to file the same reports and statements as those trading on the NYSE or NASDAQ. Even if the company does trade on NASDAQ, penny stocks get little analyst coverage, so you'll need to dig deep for valuable data about these types of stocks.
Gauge management quality
Good guys don't always win in markets, and questionable executives frequently get second chances. If you want to invest in penny stocks, review each company's management team and make sure you aren't giving money to someone with shaky ethics.
Check disclosures
Buying penny stocks often requires using broker-dealer networks; as mentioned above, accurate information can be scarce. Brokers facilitating penny stock trades must provide investors with specific disclosures about bid/ask spreads and reveal any compensation salespeople receive from trading.
Fundamental analysis
Once you’ve collected your research, use it to compare penny stocks across the sector (or to compare different sectors of penny stocks). For example, if you are comparing 2 drug manufacturers in the medical sector, you’d compare their pipelines and upcoming calalysts and then select the companies with the most promising candidates. But if you were looking at companies in the retail space, you’d want to look at figures like gross margins and cost of goods sold (if you can find it).
Beware of penny stock "gurus"
Use caution when engaging with anyone promoting penny stocks. These so-called gurus claim to have information about a catalyst, like a biotech company receiving approval for a drug or an apparel manufacturer landing a deal with a big box store. But in reality, the guru has already purchased the shares and plans to execute an old-fashioned pump and dump when his followers rush in to buy the shares. Many of these "experts" even have the nerve to charge for their made-up tips! A good rule of thumb is to avoid anyone claiming to have inside info about stocks, and that's doubly true with pennies.
Penny stock trading strategies
Penny stocks aren’t meant for long-term investment, so strategies for trading them basically boil down to two schools of thought:
- Day trading: Some traders hold stocks for a matter of hours, minutes or even seconds. (Or in the case of high-frequency firms, fractions of a second). These are the day traders, who use technical signals for short-term opportunities and seek to never hold a position overnight. Day traders look for volatile stocks and seek to pile up small wins while cutting losers without delay.
- Swing trading: Swing traders don’t have strict rules about holding overnight, but their time frames are still measured in days or weeks, not months or years. Swing traders use a combination of technical and fundamental analysis when selecting stocks. For example, a swing trader might track stocks using moving averages and other momentum indicators, but will also stay on top of catalysts, earnings reports and current events that could affect the stock price.
Penny stock warning signs
A few penny stock red flags to be aware of include:
- High bid/ask spreads: High spreads are usually a sign of a very illiquid stock. The higher the spread, the harder it is for a broker to locate the shares. Stocks with high spreads could be challenging to sell, especially in declining markets.
- Enforcement actions: Avoid companies frequently in the crosshairs of the SEC.
- Continued share issuance: Here's a common practice from poorly-run penny stocks: a company consistently issues new shares and then performs a reverse split to get the share price back up. There are plenty of legitimate reasons to issue new shares, but penny stocks that constantly pump out new shares are likely just attempting a cash grab.
Benefits of penny stocks
It's not all doom and gloom with penny stocks, but you must have the right temperament and trading style to succeed. Here are the two major benefits of trading pennies:
- Cheap to own: As long as spreads and commissions are low, you can amass a penny stock position quickly and without using much capital. Building a diverse portfolio can be difficult without sufficient capital, but pennies allow traders to own multiple companies without devoting much money to the positions.
- Quick profits: Very few traders own penny stocks because they believe in the company's long-term mission. Instead, it's a fast and cheap way to pile up profits, especially if you can locate pennies worth money. A well-timed penny stock trade can reap triple-digit gains in a very short time frame.
How to decide whether you should buy penny stocks
Can you make money in penny stocks? You can, but penny stock trading has many similarities to gambling. Information about these companies is limited, and volatility will always be high.
If you're deciding whether to start trading with a penny stock strategy, ask yourself a few pertinent questions first:
- Can I stick to my rules and avoid emotion when trading?
- Can I afford to lose all the capital I'm investing in penny stocks?
- Am I adept enough at deciphering technical trading signals to be successful?
If you answered no to any of these questions, penny stock trading might not be for you. But if you can handle your emotions, stick to your plan and not blow up your account, you may have success as a penny stock trader.
Risk management
Successful penny stock traders have strong risk management techniques and always stay as close to their plan as possible. While the unexpected happens frequently in markets, penny stock traders should have a few key risk rules to prevent blowups.
- Keep position sizes small. Don’t put too much of your total account value into a penny stock and never double or triple down on position.
- Set profit goals and sell when they’re reached. Penny stocks are volatile and momentum can turn quickly. Setting goals helps keep emotions in check and prevents overtrading.
- At the same time, be ruthless when cutting losers. If the trade turns against you, exit and forget it about. No one has a 100% hit rate.
Are penny stocks worth it? The verdict
Are penny stocks worth it? The answer depends on the type of investor you want to be. They aren't a path to long-term riches but short-term trading vehicles for quick profits. If you've been investing long enough, you know that any quick profit comes with a large serving of risk.
While buying penny stocks may not require a ton of capital, trading them successfully requires time, energy and quick action. Penny stock traders can't sit on their positions and let compound interest go to work; they must constantly monitor their trades and pick precise entry and exit points.
It means staring at screens, plotting on stock charts and looking for technical indicators. It also means looking for catalysts, tracking new stories and staying up on company data releases. It's a tedious job, and there's no guarantee that even the best-planned trades will be successful. If you're new to the world of penny stocks, practice with a paper trading simulator before putting any of your hard-earned money into these stocks.
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