What are penny stocks, and why do they appeal to most investors and traders new to the stock market?
In this blog, we will cover what penny stocks are for beginners, the truth behind these companies, and what we believe is the best way to take advantage of these penny stocks as a day trader and investor.
Intro to Penny Stocks
We all know that investing in stocks means owning a small percentage of a big company like Apple (AAPL), which has a market cap of $900 billion. Market cap states to the total dollar value of a company’s shares. Investors use it to determine the size of a company.[1]
As shown in our example, Penny stocks have a much smaller market share than Apple. Typically, “cheap” stocks are companies with a market cap of lesser than $300 million (small cap), and some are even less than $50 million (nano cap).
Definitions vary, but the Securities and Exchange Commission (SEC) classifies penny stocks as companies that trade for less than $5. If they are worth more than $1, many still trade on the regulated stock exchanges Nasdaq or NYSE.
However, penny stocks are companies that trade for less than $1. We call these “red stocks” –the companies that Jordan Belfort introduced in the movie “The Wolf of Wall Street.” They trade on the over-the-counter (OTCBB) exchange. Sounds good, but penny stocks carry an element of risk.
Why are these penny stocks considered risky?
1. A lack of information available to the public
The first and biggest reason is the lack of information among the public. This only applies to OTC penny stocks that trade at $1. Red List companies are not regulated by the SEC and are not required to prepare financial documents for their investors. Without these documents, like the 10K, investors cannot know about cash flow, operating expenses, or whether these companies are making money.
In the case of small-cap stocks above $1 listed on the Nasdaq and NYSE, the SEC requires these companies to file audited reports, register for offerings, and notify investors of essential updates. In this sense, penny stocks above $1 are a little riskier than valid penny stocks on the OTCBB.
2. Misinformation and Pump and Dumps
The second main reason why penny stocks of all denominations are considered risky is that they are still structured and can be easily manipulated through disinformation, bombing, and dumping.
Many of these penny stock companies publish news and pay promoters to boost their share price with sensational headlines discussed in many penny stock videos. Press releases for dinar stocks often include keywords such as “deals,” “contracts,” “development,” “strategic positioning,” etc. in the headlines.
These are emotional keywords because these penny stocks take advantage of the fact that most investors and market traders are lazy and don’t read the headlines. Suppose you read and analyse all the PR articles, like I did in some videos. In that case, you will see that the content is mostly fluff and doesn’t make any absolute promises about the company’s earnings potential.
Of course, the goal of the PR engines is to drive the stock price up one hundred percent, as seen in examples like $OPTT, $BPTH, $YRIV, and $ABIO. When the stakes get high, the insiders of these penny stocks start selling millions of their shares to unknown investors. Sometimes, these penny stocks will use the inflated stock price to make offers and raise more money for their companies.
“Legal” Pump and Dumps
We have seen examples of these OTC stock bombs and dumps. These penny stock companies hire third-party online advertisers to send emails and publish fake articles.
While many claim that NASDAQ penny stocks are more regulated and governed than OTC penny stocks, the truth is that these interesting press releases are what are considered “legal” pumps and dumps.
This practice is starting to continue in a grey area because, while it is very common, it is legal from the SEC’s perspective to publish interesting news about a company to investors.[2]
There have been extreme cases of NASDAQ manipulation with penny stocks like $LFIN and $HUNT. Both companies published misleading news to drive their stock prices up from under $10 to $100, essentially a 1000% ROI. Both companies were investigated by the SEC and delisted from the NASDAQ OTCBB.
Let’s be honest, though. These two delisted companies represent less than 1% of all waste management systems on the market. Unless it’s a secret business or manipulation like $LFIN and $HUNT, PR bombs and garbage from small listed companies are a daily occurrence in the stock market. I want to raise awareness for new entrepreneurs and investors because it happens.
Penny stocks are inherently risky investments. It’s always safer to be suspicious of penny stock ads, PR releases, and stock chat room tips, so always do your due diligence on a company.
Penny Stock Misconceptions
While I think some penny stocks can offer great profit opportunities for day trading and swing trading, I would not invest in penny stocks at all unless you have inside information about the company.
Two common misconceptions about penny stock investing are that many of today’s biggest companies, like Apple and Amazon (AMZN), were themselves once penny stocks and that if an investor can buy an investment for 20 cents a share today, then they can make it 100% fast if the stock price hits 40 cents tomorrow.
Both of these misconceptions are entirely untrue. We must remember the sole purpose for which private companies decide to go public. Companies go public and sell their shares to investors to raise money, fund their research, and perhaps develop the products they sell.
Stocks are not listed so investors can make money; that is not the priority. They are designed to move capital from your pocket into the company’s bank accounts. If companies are truly profitable and legitimate, their shares will increase in value and make money for investors.
The Reality of the Situation
This is only true for profitable companies with genuine products, like Apple. The truth is that most penny stocks lose money and don’t provide any actual returns. Instead, they keep selling their shares to investors and raising more money to operate and pay board members until they go bankrupt one day. In these unfortunate situations, penny stock investors lose 100% of their investment, and the insiders walk away clean with their salaries and bonuses paid by investors.
While it’s true that the price of some penny stocks going from 20 cents one day to 40 cents the next can provide some investors with a 100% return on investment, most people don’t see the flip side. A penny stock can easily fall to 5 cents in a day, in which case investors would lose 75% of their money in two days.
Often, when these penny stocks are delisted from the NASDAQ OTC market, their share price continues to fall and fall due to issuance, dilution, etc. So, it is not unusual for investors to lose almost every penny of their savings.
Can money be Made From Penny Stock Trading?
There is much money to make by penny stocks and swing trading. However, this means you buy and sell penny stocks over days or months, not months or years.
Every once in a while, companies with OTC stocks have done very well, have shown impressive growth, and have finally met the requirements to list their shares on the Nasdaq or NYSE. A marijuana stock called Aurora Cannabis ($ACB) is a good example. Their shares have been listed on the OTC market as $ACBFF since October 2018. However, the likelihood that most of their penny stocks will be like Aurora Cannabis is very slim.
Instead of investing your hard-earned money in these stocks, a more brilliant long-term decision would be to invest in established companies like Apple, Facebook (FB), and Disney (DIS). Sure, you may not be able to own as many shares as you would if you bought penny stocks trading for $1, but the long-term percentage growth of established companies is undeniable. These investments are also much safer.
Investing in or trading any security involves risk. Before investing in any penny stock, research and build your risk-reward profile. Always be suspicious of PR releases and do not follow warnings from others.
Disclaimer
This article is not financial advice for buying or selling any stocks. Still, it is intended only to inform you of the possible risks associated with penny stocks and the overhead costs of learning how to day trade or trade correctly.