Your Guide to Investing in Penny Stocks
Penny stocks have held a certain fantasy appeal to many investors.
There are tales out there, often more myth than truth about stocks being purchased for mere pennies, then blowing up to huge valuations, delivering previously unimaginable riches to ordinary investors.
Then there are the cautionary tales – the “Wolf of Wall Street” stories where fast-talking investment managers con investors into putting their life savings on “the next big thing”, only to lose every cent.
The truth of penny stocks lies somewhere in the middle. Yes, there have been some big wins and major losses, but there are also those who have made respectable returns without any major headlines.
To be clear, you can make some decent returns investing in penny stocks (especially the cannabis stocks that we trade) but it is a highly risky investment strategy.
Here’s what investors should know before venturing into these stocks:
What are penny stocks?
The definition of penny stocks will change slightly depending on who you ask, but according to the SEC, a penny stock is any stock trading below $5.
There are those which may trade at less than $1 as well and you won’t find them on exchanges such as Nasdaq and NYSE. Their rules prohibit and delist stocks which trade at a bid price of less than $1.
Of course, there are exceptions such as Adidas (OTCMKTS:ADDYY) which trades on the OTC and is technically still considered a penny stock even though it trades at MUCH higher than $5 a share.
Instead, the primary mechanism for trading these true penny stocks is the OTCBB (over-the-counter bulletin board).
The low prices mean that investors might own thousands of shares in a company for relatively low investment, meaning that increases or decreases of a few cents can make a huge difference in the value of their holdings.
What are the risks?
Penny stocks have often been characterized as a bit of a “wild west”, especially in comparison to the well-publicized and strictly regulated Wall Street stock exchanges.
Unfortunately, they have had a reputation for attracting shady characters and scam artists.
The story behind “Wolf of Wall Street” was based on the real-life exploits of Jordan Belfort, who made millions with his “penny stock boiler room” and was convicted for manipulation of the stock market.
While his is an extreme case, there have been others like him so investors are best off proceeding with caution.
There are some typical characteristics of penny stocks which you should be aware of:
- They tend to lack liquidity, meaning that they cannot be rapidly sold or if they are sold, the act of selling can impact the bid price greatly.
- They often have limited disclosures – it may be difficult to get a lot of important company information.
- The companies tend to have low market capitalization, or market value of the outstanding shares.
- They tend to have large bid-ask spreads. This is the difference between the highest price a buyer is willing to pay for stock and the lowest price a seller is willing to accept.
- They are prone to volatility. This can be good or bad for the investor. You might see the stock you bought at 15 cents jump to $1.20. If you’d put down $1000 in the first place, that’s a jump to $8000 value, but that doesn’t mean you’ll be able to sell at $1.20. That low liquidity factor may mean there isn’t a strong demand (although it can happen, which is one of the attractions of penny stocks).
All of these characteristics factor into penny stocks being a risky investment.
The bottom line is that you shouldn’t sink life savings into them, you should only invest as much as you are prepared to lose.
Those who successfully work with penny stocks tend to follow a strategy where they invest and reinvest a set percentage or amount.
How to invest in penny stocks
As mentioned, penny stocks trade on the OTCBB, but there are other channels on the decentralized OTC market, such as OTC Link. You’ll also hear the term “pink sheets” which is referring to the daily publications with bid and ask prices for OTC stocks and market makers who trade them.
It’s important to note that Pink Sheet stocks are not SEC registered and aren’t subject to listing requirements, whereas OTCBB does maintain some minimum listing requirements and is SEC registered.
For this reason, I would lean toward OTCBB over Pink Sheets just to have that extra level of legitimacy.
To clarify though, while OTCBB does require the companies registered with them to stay current on their SEC filings, the standard of those filings is at bare minimum.
This means that reporting standards are not as high as those expected of companies on regular exchanges.
To buy penny stocks, you can go through a stockbroker just as you would to buy stock on a regular exchange.
It’s crucial to select a good broker who is accredited and has a good reputation for stock trading.
You should look at their fee structure closely as this can impact your true returns heavily.
You should also look at any volume or trading restrictions they may have.
NerdWallet recently spent over 300 hours analyzing online stock brokers to come up with some of the best.
They give some good food for thought in their feedback and it’s worth noting that having an online or mobile platform should be one of your requirements of a broker.
If they still only do call and trade, there can be undesirable price fluctuations while you’re waiting for your order to be placed.
Red flags to look out for
Unfortunately, much like anything which seeks to attract investors by promising large returns, penny stocks tend to attract a number of known scams or dicey practices.
Here are a few “red flags” you should look out for and avoid:
“Pump and dump”
This is probably the best-known scam of penny stock trading.
Pump and dump is where stock prices are artificially inflated through heavy promotion.
This is usually because the promoter bought a lot of stock at a low price and wants to be able to dump it at the higher price.
Those who invested after being promoted to then find themselves with useless stock.
Enron is a famous example of one sense of “pump and dump” at work.
They used bad accounting practices to artificially pump up stock prices, meanwhile, their executives were cashing out and living the high life.
Not all promotions are dicey, but they should be a red flag telling you to investigate further.
As an example, there are a few free newsletters which highlight penny stock buying opportunities, but often these are paid advertisements.
You’ve got to question the motivation behind promoting the particular stock.
These newsletters are often vaguely labeled and difficult to trace back to a real person or entity.
They might claim to have “insider information” which informs their recommendations.
The same can be said for other advertisements.
You might come across advertising on a totally legitimate website, but the site itself is not controlling the ad that you see.
The ad may have been placed by a distribution network and can include anything from anyone who has paid to place one.
Your best defense here is simply putting the time into doing your own homework.
Penny stocks are always a risk, but there are some criteria you can look out for to help minimize that risk.
Long term averaging
This is a scheme where investors are encouraged to keep accumulating a penny stock, even as it goes through price dips.
Investors will be told that they can expect windfall profits once the stock prices take a positive turn.
The thing is, no one can honestly tell you that a windfall is coming, or that stock prices will turn positively.
All you can really do is manage your risk and try to pick some stock based on a set of criteria you have and avoid over-extending yourself.
Penny stocks seem like a nice, accessible investment, but honestly, they are not for everyone.
There have been many average investors who have had penny stock strategies backfire, causing them major losses.
The bottom line is that there is the potential to lose everything you have put into the penny stocks and find yourself holding a pile of useless shares.
On the flipside, you can always find investors who have done very well out of penny stocks – it all depends on your own risk appetite.