Penny stocks have been around for a long time but are penny stocks a good long-term investment?
In the movie “The Wolf of Wall Street”, con artist Jordan Belford gets his start selling worthless stocks to unsuspecting retirees.
Often sold on promises of large potential gains, most of these equities were known as ‘dirt sheets’ or ‘pink sheets’ since they were small or new companies that weren’t sold on major exchanges.
Obviously, most of these stocks went to zero and the investors lost everything while Belfort pocketed commission fees.
Penny stocks can be an enticing bargain – cheap, affordable shares with the potential for large price swings. But volatility works both ways and penny stocks aren’t always great long term.
In fact, they’re usually priced that way for a reason.
What are Penny Stocks?
A penny stock is the equity of a very small company sold off of the traditional market exchanges, usually because they can’t keep their value above $1.
A share price of $1 is usually the bare minimum required for listing on a major exchange like the New York Stock Exchange (NYSE) or NASDAQ and dropping below that mark puts a company in danger of getting the boot.
The real definition of a penny stock is any share that trades below a price of $5, at least according to the SEC. You can occasionally find these shares available on the major exchanges, but most can only be purchased over the counter (OTC).
Two types of OTC penny stocks exist: the OTC Bulletin Board stocks and the pink sheets. Based on the Jordan Belfort anecdote above, you can guess which group is sketchier.
Bulletin Board stocks are listed on a computer network and must meet certain SEC requirements for listing. Pink sheets only need to meet requirements laid out by the OTC exchange and are under no obligation to report any data to the SEC.
While Bulletin Board stocks must meet certain SEC requirements, these are much less invasive than the requirements for companies listed on major exchanges like the NYSE.
And pink sheets?
Good luck getting any reliable data from them. Trading stocks always carries some level of vagueness and ambiguity, but penny stock trading truly leaves fundamental investors in the dark.
Why are Penny Stocks Riskier Than Traditional Stocks?
It’s true that every company has to start somewhere and some penny stocks have risen into worthless investments over the years.
But remember, penny stocks trade on the Bulletin Board or pink sheets for a reason. Here are three of the biggest risks facing penny stocks.
- Poor Company Prospects – Let’s not beat around the bush: most of the companies listed on OTC exchanges are bad companies. They are often saddled with debt, hiding some type of fraud, or managed by bumbling or inexperienced executives. The next Amazon or Google isn’t sitting on a pink sheet and 99% of these companies will never turn a profit.
- Not Traded on Major Exchanges – In order to be listed on a major exchange like NYSE or NASDAQ, you must have certain capital and volume requirements. For the NYSE, a company must have a $100 million market cap and at least 1 million shares in circulation. Major exchanges also require more disclosure with the SEC. Penny stocks are often illiquid issues with opaque financial statements.
- Frequent Targets of Scammers – Low volume? Check. Highly unregulated? When low float stocks trade in unregulated markets, that’s the Bat Signal for pump and dump scammers. Since penny stocks often have few tradable shares and low market caps, the stock price can easily be pumped by a single large purchase. And since these markets face less scrutiny, scammers are all too eager to hoist them on unsuspecting investors.
Trading vs Investing In Penny Stocks
If you must trade penny stocks because the volatility is just too enticing, you’ll need to set realistic expectations of your outcomes.
Trading penny stocks is like playing penny slots at the casino – you’re gambling, plain and simple. Most penny stocks are backed by terrible underlying companies with sketchy balance sheets.
Since company fundamentals will almost always be poor with penny stocks, the only other two avenues for success are insider information or technical analysis. Insider trading is illegal and certainly not worth the risk when it comes to lowly penny stocks.
With floats and market caps so low, it won’t be difficult to figure out who was trading on non-public information.
Technical analysis can be utilized when trading penny stocks, but remember that technical analysis is the study of other traders, not the stock itself. Higher volumes make technical analysis more accurate, which is why support and resistance signals have better results with more liquid shares.
But penny stocks are often illiquid equities with low floats and minimal volume. When shares are traded so thinly, locating slam dunk buy and sell signals becomes far more difficult.
If you’ve ever traded in pre- or post-market hours, you’ll understand how low volume and weak liquidity can turn your trading strategy on its head. Getting in and out of positions can be difficult. If your trade turns south, you might not be able to find a taker for all the shares in your position.
Don’t invest any money you can’t afford to lose in penny stocks.
It’s better to day trade them with a firm understanding of your risk exposure and technical analysis. Both of which we teach in our courses.
Bottom Line
Trading penny stocks is a risky endeavor not recommended for the faint of heart. But investing in penny stocks for the long term? That’s just foolish.
Penny stocks are risky long term investments since many of them turn out to be debt-riddled frauds. Listing requirements for major exchanges might be tedious, but they aren’t exactly discriminatory.
If a company fails to make the grade, it’s almost always for a legitimate reason.
Yes, penny stocks occasionally produce big returns, but that’s usually over a short time frame more suited to day and swing traders.
Penny stocks can certainly double or triple up if you time them right, but they’re also illiquid. Even a quick double-up isn’t a guarantee of profit since you still need to unload the shares before they come back down and willing buyers might be in short supply.
Always understand the risks of trading penny stocks and never treat them as long-term investments.
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