Penny stocks are risky, full stop. Because they are cheap,they are tempting for inexperienced investors,but they have wild price fluctuations, which does offer the possibility for huge gains if you time the market right. The problem is, it’s almost impossible to do that. More often than not, people lose their shirts trading penny stocks. Penny stocks are fraught with risks most experienced traders and investors take care to avoid.
First of all, most companies trading OTC or on pink sheets are of low quality. Their balance sheets are a disaster, they are operating at a loss, and their financials in general are a train wreck. Even worse for investors, these companies aren’t required to disclose the financial information that analysts and retail investors use to evaluate a stock. The information you do find is often inaccurate and promoted by scammers who want to pump and dump a penny stock.
If the company was doing business legitimately, turning a profit, being transparent about its operations, it would be able to get listed with an exchange. The fact that these companies trade over the counter should be a big red flag.
There’s also a risk of valuation inflation, especially when a penny stock catches the public’s attention. The rumor mill can easily cause a buyer stampede, falsely driving up the price of a penny stock. This happened recently when Tesla announced it was acquiring Riviera Tool LLC. Riviera Tool LLC was a privately held company, but it had been publicly traded as Riviera Tool Co until 2007. Shares in the old company made it onto the pink sheets, essentially inactive and trading for less than a cent a share. On the day of the Tesla announcement, however, speculators rushed to buy them, driving the price to $0.60 in a single day. Of course, the shares were worthless, since the company no longer existed, and a lot of speculators lost a lot of money.
Another risk is that these are highly illiquid stocks, meaning they have extremely low trading volumes. An investor who wants to close his position may have a very hard time finding a buyer, and the spreads will be much larger than for high quality stocks.
Imagine you’re a penny stock trader with a $5,000 stake in a company with an average daily trading volume of 10,000 shares (and there are penny stocks that have these kinds of painfully low volumes), and a daily range of $0.25 to $0.30. You couldn’t dump all your shares at once because it would drive down the price significantly. You’d have to sell them off bit by bit over a period of days or weeks. If you did try to sell the whole batch at once, your order might sit unfilled for days because there aren’t enough buyers at that price.
The same thing would happen in reverse if you tried to buy a $5,000 stake in the company. You would have a hard time filling the order, because there aren’t enough sellers. You’d have to offer substantially more to incentivize more shareholders to sell.
Then there’s the issue of trading itself. Most brokers charge higher commissions for OTC trades, and you usually can’t place special trades like a stop-loss.
Occasionally, a blue chip can run into financial trouble and end up in penny stock territory. A spectacular example is Fannie Mae and Freddie Mac, which were highly profitable and traded on the big boards prior to the financial crisis. Today, they’re on the pink sheets. GM was also delisted after it filed for bankruptcy in 2009; shares were trading at $0.75. Citigroup was removed from the Dow when its share price fell below $1, and today it’s trading above $60.
The bottom line? There are occasionally really big winners in penny stocks, the losers are far more common. If you do decide to trade penny stocks, know that you do so with a high level of risk.