Penny stocks are high risk mainly due to the lack of liquidity and company information as well as the high volatility associated with lower priced stocks.
Many day traders looking to make money in the stock market prefer to buy low-priced stocks. This is because they offer higher than normal returns.
Penny stocks can be very risky if you don’t apply a sound trading strategy.
In this post, we look into understanding penny stocks and some of the risks that are commonly associated with them.
What is a penny stock?
In financial markets, the term “penny stock” refers to shares of a company that trades for very low prices—usually, in the range of $0.01 to $5.00.
However, there are no specific rules regarding this definition and some institutions consider penny stocks as any security that trades below $5.00.
In most cases, these stocks belong to troubled companies with tiny market caps that are not listed on major stock exchanges.
While you may find some penny stocks listed on the NASDAQ or the New York Stock Exchange (NYSE), most of them are traded on over-the-counter (OTC)/pink sheet markets, or on the electronic OTC Bulletin Board (OTCBB) system.
Why penny stocks are so popular
The number one reason why penny stocks are so popular is the fact is that you can begin to trade with a relatively small amount of money. I would say at a minimum you could start with as little as $1,000.
Most of these stocks change hands at between $0.10 and $1.00, which means with a small account. With a $1,000, you can buy 1,000 shares of stock if it is trading at $1.00, or 10,000 shares if it is trading at $0.10.
Another reason is the fact that a small move in a penny stock can lead to huge returns. As earlier mentioned, most penny stocks trade at or below $1. Therefore, even rising just a few cents can result in high percentage returns very quickly.
Let’s say, a stock only moves from $0.10 to $1.00, you would 10x your money. This is the kind of thing you hear a lot of traders hyping up.
The risks of trading penny stocks
Now, let’s look at the risks of trading penny stocks. Why does the market regard these stocks as high-risk investments?
They are often listed by phony companies
Well, the main reason is why penny stocks are considered risky is because most of them are tied to companies that are just getting into the market and hoping to raise revenue fast. In some cases, some of these businesses are even downright fraudulent.
The companies don’t receive the same level of scrutiny as those whose stocks trade on listed exchanges. For this reason, any information you find about them may not be from a reputable source, and they can fly under the radar.
Prone to “pump and dump” schemes
In addition to being offered by questionable companies, the other risk of trading penny stocks is they are frequent targets of pump and dump schemes.
A pump and dump scheme is the practice of scammers promoting a given stock in order to push its price higher through short-term hype and earning hundreds of thousands of dollars in the process by selling out themselves at the top (dumping).
This illegal practice ends up leaving innocent traders who bought the stock at its ascent with massive losses as the stock tumbles.
Penny stocks are highly illiquid. These stocks also tend to have higher insider ownership and leaves a smaller free float for the general investing public.
This means that even if the price of the stock goes up, many traders may not be able to sell the stock before it drops again.
They are historically extremely volatile
For individuals in penny stocks, the cheap share price is a big draw. However, these very low stock prices mean they are extremely volatile and their movements can go up more than 100% in a single day.
These wild gyrations happen when a fundamental catalyst of some sort brings many new buyers into the stock. A catalyst can be anything from a press release, a rumored buyout, earnings, activist investors, a new contract, an FDA announcement, or some other kind of breaking news.
On the downside, if a stock can go up more than 100% within a day, it means that it can also go downhill in the same measure.
How to protect yourself from the risks
Penny stocks are very appealing to first-time day traders because of their low prices. But these stocks are also a magnet for fraudsters and scammers who profit from misunderstandings and misconceptions.
So, how can you protect yourself from the risks associated with these stocks, including pump and dump schemes?
The simplest answer is to avoid penny stocks that are listed on unregulated over-the-counter markets. If you want to try your hand at stocks under $5, stick to those that are listed on regulated exchanges such as the NASDAQ, the NYSE, or AMEX.
Moreover, thorough research of penny stocks before trading can help you avoid huge losses. Don’t follow free penny stock picks and they will most likely trick you into buying by using dishonest tactics and information, and dump the stock as soon as they convince enough people to buy.
Identifying the best penny stocks to day trade is an excellent tactic for profitability. But like many things in life, finding the best ones is much easier said than done.
The most important thing to keep in mind when trading penny stocks is that these instruments are highly speculative. All stocks are speculative to some degree, but the low price of penny stocks makes them especially vulnerable to wild intraday swings based on news events.
Ultimately, informed and disciplined traders can make money trading stocks under $5 penny.