Penny Stocks are sold as the holy grail for people with less money to get rich quick. I traded them many years and lost a lot of on them. With this article, I want to share my experience with penny stocks as well as showing a different, more secure way to make money in the stock market even if you don’t have a lot of money.
Almost all penny stocks have a failure percentage of 100% and will inevitably move to 0 at some point. These companies usually have a terrible financial structure and are deemed to fail. Heavy up-moves are typically due to heavy speculative news that also doesn’t last long. Let’s go into some details about why they fail and why they are dangerous to trade.
Why penny stocks are deemed to fail
Definitions of what a penny stock is can vary. When people talk about penny stocks, they usually refer to micro-cap or nano-cap stocks with a market price of below $5. Micro-cap means that the company’s market capitalization is extremely low between $50 to $300 million (below $50 million for nano-caps).
Here is a list of reasons why penny stocks are deemed to go to 0 and are very risky to trade:
1. Weak financials
The companies behind penny stocks typically have a terrible financial structure with an ineffective business plan. They will most likely go out of business at some point in time.
2. Lack of information
If you want to invest in stocks, you have to gather information about the company to make an informative decision if you wish to invest in the company or not. Finding information for these companies can be very difficult. If they are listed on pink sheets, they are not even required to file with the Securities and Exchange Commission (SEC). As a result, they are not as publicly scrutinized or regulated as companies listed on the New York Stock Exchange (NYSE) or Nasdaq. Furthermore, a lot of the information comes from less credible sources, which makes it very prone to fraud.
3. Failing to meet minimum standards
Some exchanges have minimum standards that those companies need to meet. Nasdaq, for example, requires the stock price to stay above $1. If the price falls under that, they will get delisted from the exchange and open up on a smaller exchange like the OTC (Over the Counter) with fewer restrictions. That’s why you see penny stock companies continuously try to do reverse splits of their stock to stay above those minimum requirements. Ultimately, these standards exist as a safety cushion for investors. The smaller the exchange, the less safety there is.
4. No history
A lot of the companies are either newly founded or are approaching bankruptcy. These companies will inevitably have a terrible track record or none at all. Without any track record, it makes it extremely hard to make an informed decision on the stock’s potential.
5. Prone to scam
Since these companies are much less regulated, they are targeted by people for manipulation purposes. Some micro-cap companies even pay private individuals to spread positive bias for their stock on social media to pump up the price. They sell their shares into the pump for huge profits while investors are stuck with their overpriced position. The stock will most likely move back down to its original price. That is why investors should take information about a stock posted on social media with a grain of salt.
Liquidity can be a huge issue
Micro-cap stocks typically have a very low float (available shares for public trading). The smaller the float, the faster the stock moves. You may have a hard time finding a buyer for your shares at the desired price and end up getting filled at a terrible price. This happened countless times to me. So if you want trade those stocks always use limit orders to not suffer from slippage!
Low liquidity also opens up the doors for people to manipulate stock prices. By issuing large orders, they can drive the stock price to their advantage. They will also hype up the stock in the meantime and then sell it into the pump. This technique is also known as ‘pump & dump.’
Trading halts can destroy your account
When penny stocks move, they have significant percentage gains. These gains typically happen very fast. Stocks can get halted if they move too fast. The typical halt occurs if the stock moves more than 10% within 5 minutes. These halts usually lift after 5 to 10 minutes. There is no way to predict where the stock opens up again, which can have a destructional effect on your account.
The exchange itself can also issue a halt if they think that these price moves are very unusual. They will start to investigate, which could also bear the danger of the stock getting delisted from the exchange.
One of those prime examples is LFIN, which shot up from $3 to $140 within a few days on Nasdaq. It got halted for a few months because the company was accused of fraud and manipulating the stock. It never opened up on the Nasdaq again and was moved to the OTC market.
A better way to trade with little money
People mainly pick penny stocks because of the enormous gains they can provide and because the share price is affordable for their small accounts.
As I laid out, there are enormous risks involved in trading these micro-caps. A much safer way, especially for beginner traders, is to trade well-known companies with higher market capitalization. These mid- to high-cap stocks are well regulated and can hardly get manipulated.
Now you probably think: “But I need a big account to make a significant gain which I don’t have the money for!” – Here is where you could make use of leveraged accounts.
WHAT IS LEVERAGE?
Leverage is simply an increase in buying power, which means that you can buy more stock than what your account size would allow. Let’s say you have a 6:1 leverage and $1,000 in your account. That would mean you can buy stock worth $6,000.
To give you an idea of how far leverage could go: Tradenet’s smallest package gives you a 35:1 leverage with a $399 investment. So that means you can buy stock worth $14,000 with very little money.
To make it even more clear how leverage works, I made an illustration down below.
As a disclaimer, you also have to be careful trading leveraged accounts and build a good discipline while you trade. The risk is much lower though since you are not trading ‘trash’ companies.
Conclusion
Penny stocks are hazardous to trade, and a high percentage of them is going to fail. People think that these companies work their way up to the more prominent exchanges, but most of the time, it is the other way around.
As a beginner trader, you should stay away from penny stocks and consider higher-priced stocks from reputable companies. Leverage can help you trading these types of stocks when you don’t have a lot of money to invest.