A lot of investors are drawn to penny stocks’ promise of huge returns. And it’s true that these shares have massive price swings in the high double and even triple digits, usually over a fairly short period of time. The extreme volatility is just one reason penny stocks are risky and highly speculative assets. Only trade penny stocks with money you can afford to lose.Although penny stocks are defined as any stock that sells below $5 a share, there are quite a few that trade for literal pennies, or even fractions of pennies, which means you can buy a lot of shares with a relatively small investment. A $500 investment can buy 1,000 shares of a penny stock trading at $0.50; that same investment would buy just 10 shares of value stock Delta Air Lines. It’s tempting to think there is some huge advantage to having 1,000 shares versus 10 shares, but a 10% gain on a $500 investment is the same, regardless of the number of shares you own. Don’t confuse price with value when you’re dealing with penny stocks.How much you need to trade penny stocks depends on your brokerage account minimum requirements. All online brokers trade stocks on the major exchanges, and there are plenty of stocks under $5 on the big boards. However, both Nasdaq and the NYSE have rules about stocks trading below $1. For true penny stocks, you’ll need to find a broker that handles trades on the pink sheets and OTC bulletin boards. Most, although not all, do. You’ll usually need to have at least $500 to open an account, and there may be other conditions if you’re trading penny stocks.Because penny stocks are not long-term investments, you make more trades, so it’s important to understand your broker fees and any other restrictions or conditions they have on penny stock trades. If your broker charges a surcharge or has limits on the number of shares you can trade in one order or one day, it eats into profits, especially on the low-dollar trades.Some people get into penny stocks because they see them as a way to get into the market without a lot of cash. But if you’re making $100 trades and your broker fees are $15 round trip, you’ve got to make 15% on the trade just to break even. If you’re making $1,000 trades, on the other hand, $15 in broker fees isn’t as much of an issue.The next thing is how often you plan to trade. If you trade often enough to meet the SEC’s definition of a pattern day trader, which broadly speaking means you make more than four round-trip trades over five business days, you have to have at least $25,000 in a margin account.When you’re trading penny stocks, you should have enough in your account to stay in the game. The nature of penny stocks means you are going to have some big losses, and hopefully a few big wins, but if you are trading with just $1,000 and you can’t close a position fast enough to avoid a huge loss on a trade, you might end up with just $500 or so in your account, and it’s very hard to make enough winning trades to recoup your losses with just $500 to trade.Most people who are serious about trading penny stocks start with about $5,000, because at that amount, you’re able to make decent-sized trades and still stay within a prudent maximum risk level of 2% per trade.Bottom line—penny stocks are volatile, high-risk, and speculative securities, and they really aren’t an appropriate choice for most investors, especially those without a lot of capital to risk. If you don’t have a lot of money to invest, or the money you do have is earmarked for other savings goals, you should think twice before jumping into penny stocks.
After-hours trading (AHT) is the name for trades made outside the standard trading hours of the exchange. The majors (NYSE, NASDAQ) trade from 9:30 am until 4 pm Monday through Friday, which happens to be the same standard hours for OTC markets, which is where most penny stocks trade.Unofficial trading hours are from 4:15 to 8 pm and 4:15 am to 9:30 am, and you can trade penny stocks during these periods, as well. In fact, some of the biggest moves happen after hours, which makes a normally volatile security like a penny stock extremely volatile.The mechanism for trading is the same before and after hours, with orders placed through your online broker service. You may have to pay an extra fee for after-hours trades, so check with your broker.The thing to keep in mind is that AHT can be extremely risky, especially with penny stocks. This is due to several reasons:
- Even lower than normal liquidity. As any penny stock trader knows, liquidity is a major issue, even during normal hours. After hours, you may find it nearly impossible to fill an order. Even if you wanted to take advantage of a sudden after-hours price spike, chances are good you wouldn’t be able to find a buyer.
- Wide spreads. This is a function of low liquidity after hours, which means that the spread between the bid and ask price will be much higher, and again, you may not be able to execute the trade at a favorable price.
- The biggest players in AHT are institutional investors, who have access to far more capital than retail investors. Although you feel the effects of institutional buyers during normal trading hours, they’re even more pronounced after-hours. This isn’t necessarily an issue with penny stocks, since they tend to be off the radar of most institutional investors but could be an issue if you’re trading a low-priced stock that isn’t a true penny stock.
- Higher volatility. Volatility is a feature, not a bug, when it comes to penny stocks, but the volatility becomes even more pronounced after-hours. Because of the much lower volume of trades happening after-hours, you’ll see larger price swings.
- The news cycle. Major releases about earnings, employment, moves at the Fed all happen outside standard trading hours. These can often magnify the effects of other issues that plague after-hours trading, such as low liquidity and high volatility.
Penny stocks have an allure for new investors that’s very deceiving. The main reason being thatthe stocks arecheap, and they have the potential for amazing returns; however,they also have the potential to crash and burn, and the latter happens far more frequently than the former. If you’re thinking of investing in penny stocks, an extra dose of caution is necessary.Penny stocks used to be defined as stocks that traded for $1 or less per share. Over time, however, the SEC has come to define penny stocks as any equity trading below $5 a share. True penny stocks aren’t traded on the major public exchanges; they trade over-the-counter through pink sheets or the OTC Bulletin Board.This is a very big deal for investors, for a number of reasons. Stocks traded on the exchange must meet stringent listing requirements including market cap, number of shares, and cash flow, and they must meet SEC filing and disclosure requirements. In other words, you have access to a lot of financial information about companies listed on the exchange. There are no such requirements on penny stocks traded OTC. You will have a very difficult time finding the type of credible information you need to make an informed decision about the stock’s value and trajectory.Penny stocks also suffer from low liquidity. It’s hard to find buyers, which means you may have to discount your shares when you want to unload them, damaging your returns. Low liquidity also leaves penny stocks vulnerable to price manipulation via pump and dump schemes. In pump and dump, stakeholders promote the stock, often by releasing misleading information about the company, in an attempt to drive up the price. As soon as the price inflates enough, the investor dumps them. The unsuspecting buyer is stuck with the inevitable loss.Short and distort is the reverse of the pump and dump scheme. In this scam, an investor borrows shares and sells them off right away. Then he spreads damaging information about the company and waits for the price to drop. When the price falls enough, he buys up the shares and returns them to the lender to cover his short and pockets a tidy profit.Now, if you understand the potential pitfalls of penny stocks and still want to proceed with adding them to your portfolio, there are good reasons for doing so. Obviously, a stock with sucha high downside also has the potential for a really huge upside; you can make a lot of money fairly quickly if you pick a winner.The Golden Rule of investing in penny stocks is only risk money you can afford to lose. Don’t try to fit pennies into your retirement account or other goal-oriented investment. Only use money you haven’t earmarked for something important for investing in penny stocks.Pay attention to liquidity and trading volumes. If you’ve done your homework and have found a good penny stock, you need to be able to sell your shares when the price is right. Penny stocks are not long-term investments, they are made for short-term trades. If you can’t sell when you need to, you could easily lose your gains in a very short time.Don’t fall for fads. People promoting penny stocks always call them the next “hot” thing. And by the time you hear about the next hot thing, chances are good the opportunity has already collapsed. Buy what you know, even in the penny stock market.Look for quality stocks—and yes, you can still find some trading below $5. Although it was never delisted, there was a time during the financial crisis when Citigroup traded for under $1 a share; today it trades at around $65. Obviously, you won’t usually see blue chips trading in penny stock territory, but you can find solid companies in a temporary downturn with a high potential for recovery. Any good stock screener can help you identify prospects.There is definitely money to be made trading in penny stocks, but you’re more likely to lose your stake than turn a profit. Don’t jump into penny stocks unless you’re willing to do a significant amount of research before taking a position.
One of the risks in trading penny stocks is the lack of verified and publicly disclosed information, especially for those trading on pink sheets or OTC bulletin boards. Unlisted stocks don’t have to disclose the same type and amount of information that those on the exchanges do.In addition, a lot of penny stock companies are new. They don’t have a track record or financial history to evaluate, leaving you pretty much in the dark about their quality and fundamentals.That leaves traders and speculators turning to penny stock newsletters and paid ads, which happen to also be the preferred sources for penny stock scammers to launch their schemes. In fact, the SEC specifically warns investors of the following types of common penny stock fraud:
- Emails spreading false information about a microcap
- Fraudsters using aliases to post on investor bulletin boards, chat rooms, and websites, promising “insider information” about a penny stock
- Paid promoters that act as unbiased analysts or experts in newsletters, radio, and TV shows to push up interest in a penny stock on behalf of a scammer
- Cold calling, which is a common technique with offshore brokers who track in unregistered penny stocks in increasingly common offshore scams
- False press releases disseminated through legitimate news sources
- Trading suspensions by the SEC. These occur when the SEC believes information about a company is inaccurate or false.
- High assets but low revenue. Penny stock companies often inflate the value of assets that have no legitimate connection to their business.
- Footnotes in the financial statements documenting unusual transactions such as loans or assets-for-stock swaps.
- High percentage of insider ownership, or high ownership by a single entity. This makes it much easier to manipulate the price and profit off a pump and dump scheme.