Penny stocks are stocks that are traded for less than $5 a share. The companies that sell penny stocks have a market cap of less than $300 million. There are primarily two types of penny stocks. The first type is traded on the Nasdaq and NYSE exchange. The second type are OTC stocks which means that they are traded over the counter (OTC). The difference between the two types is that the ones that are traded on the Nasdaq & NYSE exchange have to follow the Securities and Exchange Commission (SEC) rules and OTC stocks do not need to file any financial documentation. OTC stocks are usually traded for less than $. Penny stocks are risky to trade with, and OTC stocks are even riskier.
An important concept to understand with penny stocks is that large orders can easily move the stock price since market cap is less than $300M. Penny stocks are often referred to as ‘pump and dump’ schemes, which basically mean it will accumulate tremendous gains for a short period of time and all those gains will be dumped. Then, anyone that bought at the top will have great losses, and it is referred to as carrying the bag. This is a common scheme that happens with miss spread information on penny stock. Pump and dumps have happened due to companies paying influencers to spread misinformation to retail investors. Those people get charged but the retail investor that owns the stock loses most of their money. This is something to be aware of.
Penny stocks are attractive to some traders since most of them are traded for less than a dollar. Therefore, they can own a lot of stocks. If the stock fluctuates for a little, it can provide great gains. For example, a stock trading at $0.04 and gains +$0.01 has a return of 25% gain. If it had increased by another 3 cents, we are already at a 100% gain. This is why some traders are attracted to penny stocks since it can give wild gains in a short period, a little bit like a get rich quick scheme until the stock does not move to their favor and wipes most of their money.
Disadvantages of trading penny stocks
· Speculative, not enough information given on the company, especially OTC stocks.
· Very volatile, you can lose money very quickly.
· Large orders can easily move the price. People that have a lot of money and a big audience can easily manipulate a penny stock to their advantage.
· Penny stock companies are often not profitable companies. Not a good investment to make.
Advantages of trading penny stocks
· Attractive low prices that permits you to own a lot of shares.
· Very volatile, you can earn great gain if the price movement of the stock is to your advantage.
Do we recommend trading/investing into penny stocks?
No, we do not recommend trading or investing in penny stocks. The primary reason is that penny stock is a very speculative play since most of them do not have enough trading volume. The moment there is some news, or someone spreads trending information on a penny stock company, the trading volume spikes and stock price rises tremendously. This is due to high demands from buying and not a lot of sellers. By the time you look into it and FOMO (fear of missing out) it, the volume will lower, and people will take profit, leaving you with huge losses (if you bought at the peak thinking it will continue to rise). This does not mean every penny stock acts this way, but we want to inform you of the risk behind trading penny stock.
Investing in penny stocks is also risky since most of the penny stock companies that are not profitable businesses. Most of them are publicly traded to raise money. They need your money to grow, if it is a good company that is profitable, investors are rewarded with stock price growth, but it is not the case for most penny stocks.
If you wish to trade penny stock make sure to properly manage your risk and position size. Do not risk an amount that you cannot afford to lose, keep a tight loss. Also, investigate the company and do your due diligence on it. Do not base your due diligence on the company because someone else said it is a great buy.
We recommend the book The Complete Penny Stock Course for anyone interested in trading penny stocks and wish to learn more.