When investors hear the term penny stock, they cringe. Many of us have heard stories about people who put big money on penny stocks only to lose it all when that company goes bankrupt or fraud occurs. So to start, what is a penny stock?
Penny stocks, also referred to as micro-cap stocks, nano-cap stocks, small cap stocks, or OTC stocks, are common shares of small public companies that trade for less than one dollar per share." Additionally, because their stocks trade under $5.00, they do not meet listing requirements for the New York Stock Exchange (NYSE) or NASDAQ which adds additional volatility and risk. Most are bought and sold Over-The-Counter (OTC).
Here's a great video from TheMotleyFool:
- Extremely volatile
- High Risk of loss (there's a reason these companies are so low)
- Fraud (price manipulation and boiler rooms)
- Lack of information (small companies have less eyeballs looking at them)
- Cheaper stocks (although most high quality stocks are now available in fractional shares)
- The potential for massive gains
Why are Penny Stocks so Volatile?
Because the market capitalization (what the company is worth) is so low, it takes a comparatively small amount of money for a nefarious investor to artificially big up or crash the price of the share. This is what is seen in movies such as "Boiler Room" and the "Wolf on Wall Street".
Once the nefarious user has manipulated the price of the shares, they can then take their gains and leave retail investors (i.e. normal people) with worthless stock (and massive losses).
When I was first starting out I decided that the best way to learn was to dive in and force myself to learn by putting money on the table. Foolish you might say and maybe you are right. I only invested what I could afford to lose in the first place.
Investing in penny stocks is like gambling, so roll the dice wisely. I picked a company that we will call X. After some research I decided to enter into their ring and I bought 10,000 shares at $0.11 per share.
Looking at X's history I saw that between January and June, the stock rose from $0.21 a share to $2.77 a share, before crashing back to earth at $0.11. I calculated that if I put in a small amount I wouldn’t lose sleep over, say $1,000 at $0.11 per share, and the stock peaked again at $2.77, that would generate a quick $24,180 profit off of a $1,000 original investment – bold I know.
Days later, the stock doubled to $0.22 per share. I decided not to get cocky and sold and by the time my order was processed, the share price dropped to $0.18 per share – other day traders probably had the same strategy. I made my investment money back and close to a $500 profit and the remaining shares that I own, I will let ride. Maybe I should have sold it all...
So what happened!? My guess is that the price was pumped up by some nefarious actors as I did not see any fight promotions or chatter on media channels or sources.
While I got lucky this time, I learned how quickly the price can go up AND down, and only by sheer luck did I walk away. I highly recommend avoiding penny stocks!
The Right Strategy
I like to compare a stock purchase to shopping for an item at the grocery store. Just like you wouldn't buy a random food item without first assessing it for quality, judging it based on the company, and perhaps other consumer reviews, you also should never buy a stock without due diligence.
When looking at any stock, and especially penny stocks, learn what you are buying. Research the company, its business model, and its CEO. Consider where their market cap is and what you can see them growing into. If a stock looks and feels sketchy, it probably is best to avoid.
While I got lucky this time, I could have just as easily crashed and lost everything. Only invest what you can afford to loose!