For new or inexperienced investors, there’s an undeniable logic to penny stocks. After all, if you have $1,000 to invest and you can either buy 10 shares of XYZ at $100 a share or 1,000 shares of company ABC at $1 a share, wouldn’t it make sense to get more shares, and therefore more opportunities to make money?
Unfortunately, that’s flawed logic. Penny stocks are inherently risky, suitable for trading or speculating, but not really for investing. So if you’re ready to dive into penny stocks, be sure you’re playing with money you can afford to lose.
Look for sectors that are generally trending upward in the market as a whole. You want to take a long position with penny stocks, because true penny stocks are extremely difficult to short. Even if you find a broker that allows shorting penny stocks, the liquidity issues make it easy to get caught up in a short squeeze.
Many penny stocks trade on pink sheets and the OTC bulletin board, but most experienced traders stick to low-priced stocks listed on the major exchanges. Companies that trade on the big boards comply with SEC filings and disclose their financial information; that’s not the case with those trading OTC. Without those filings, it’s very difficult to find essential information about the company, its debt load, capital structure, and business lines—which makes picking stocks an exercise about as accurate as being blindfolded and throwing darts at a dartboard.
Beware of dilution, a common problem with penny stocks. When companies issue shares to raise capital, it has both long- and short-term effects. In the short term, it drives down the price of existing shares, and over the longer term, it makes it harder for existing shares to gain value due to dilution. Pay close attention to outstanding shares and warning signs that the company needs a cash infusion from equity capital.
Always avoid stocks with obvious liquidity problems, because you will have a hard time filling your orders, whether you are looking to buy or sell shares. Poor liquidity leads to huge spreads, another common problem when you’re trading penny stocks. Some pros recommend screening out stocks below 100,000 average daily volume, others set the limit at 250,000 shares. Just know that the lower you go, the riskier it gets, especially if you get caught on the wrong side of a pump and dump.
Current and historical trading volumes provide valuable insight. If a penny stock has a low average daily volume and suddenly sees significantly increased volumes, especially over a period of several days, that’s a dead giveaway there’s a pump and dump scheme in play.
Treat every recommendation about a penny stock as a scam or scheme until you prove otherwise. In fact, if you get an email or call about a penny stock, scratch it off your list of possibilities. This is another tip-off that a pump-and-dump is underway. Promotions to drive up interest in an otherwise obscure stock is a common scammer tool to drive up the price of a penny stock.
Recognize the two most common fallacies about penny stocks. The first is the misconception that all successful companies were once penny stocks. The second is that the number of shares you own, and your overall returns are directly connected.
The first arises because companies such as Microsoft and Apple once traded at penny stock prices. But the fact is, they were never truly penny stocks. They were nano- or micro-caps that eventually grew into blue-chip giants. A penny stock and a microcap are fundamentally different things. Penny stocks are defined by their share price, their poor liquidity, and the fact that they trade OTC.
Microcaps, on the other hand, are defined by market capitalization. They trade on the big boards, and they comply with SEC regulations and meet the requirements to trade on the exchanges. Most of them do trade in penny-stock price territory for a period of time, and most of them are very volatile like penny stocks, but there is a huge difference between a microcap and a penny stock, and traders ignore these differences at their peril.
The second is that, on a day to day basis in a stable market, the price range of a high quality stock tends to be fairly small. If an investor holds $1,000 in Pfizer stock (PFE), for example, and the price increased $0.10 on a given day, his gain would only be about $2.20, since a $1,000 stake would be about 22 shares at the current price of $45 a share.
On the other hand, if that same investor held Cyclacel Pharmaceutical stock (CYCC) and it increased $0.10, the gain would be $125, because a $1,000 stake equals about 1,250 shares.
That’s a false equivalence that has nothing to do with the number of shares, but with the percent of change. A gain of $0.10 on Cyclacel at $0.85 equals 12.5%. If the Pfizer stock gained 12.5%, it would mean an increase of $5.60 a share. If you owned 22 shares, you’d make about $125, the same as you made on the Cyclacel stock.
Volatility can be very attractive if you only look at the upside, but a stock that increases 12% today could just as easily lose 12% tomorrow, and that’s the danger of penny stocks.
Ultimately, most people who trade penny stocks ignore the underlying fundamentals, which is often a function of the lack of transparency of stocks traded on the OTC boards. For that reason alone, you should be extremely cautious with promoted penny stocks, stocks with poor liquidity, and those with a diluted share structure.