So you want to invest in the stock market? If you do a quick google search for a stock such as Alphabet Inc Class A Shares by googling, for example, NASDAQ: GOOGL, you will see a share price of around 2,736.14.
Buying one share of a company at that price is probably not something you imagined when you first considered investing or “getting into the market.”
A popular, much cheaper, but significantly riskier way to invest in the stock market is through penny stocks. Here’s how to invest in penny stocks.
What Are Penny Stocks?
Most regulators and exchanges define penny stocks as stocks with a very low share price. The US SEC (Securities and Exchange Commission) defined a penny stock as any stock with shares trading below $5. Most penny stock traders go for penny stocks under 50 cents because they can buy large volumes of shares.
Some penny stocks trade on big exchanges such as the NYSE, but you can find most of them on the Over the Counter Bulletin Board (OTCBB).
Penny stock companies have a low market cap (total cash value of outstanding shares) and have low liquidity. Large-scale institutional investors generally avoid them.
In fact, institutional investors are usually prohibited by charter from investing in penny stocks. Mutual funds and index funds are also generally not allowed to hold penny stocks.
Why do institutional investors avoid penny stocks? While some traders out there can be called penny stock titans, they are few and far between. They are an exception, not an indication of the norm.
Here Are the Reasons Big Investors Avoid Penny Stocks
1) Penny Stock Liquidity
In reference to stocks, “liquidity” is how easy it is to move shares. When it comes to penny stocks, it might be challenging to find a buyer. So, investors may experience long periods where they are unable to sell while the price can go down. Imagine buying a ton of apples for your fruit stand and having no one buy apples for weeks. Eventually, the apples are nearly worthless. This could happen with your penny stock. You might only be able to sell below your purchase price, causing you to lose money.
Apples go bad, and stocks can too. A stock may never go up after a massive dip, or the company could be delisted.
In the investment world, this is called “being stuck in an illiquid holding.” You can imagine how much of a nightmare this could be, so be careful.
2) A Min Market Cap Rule and Lack of Corporate Governance
Institutional investors are wary of penny stocks because of hazy disclosure practices and corporate governance. Many high-profile investment fraud cases are centered around pump-and-dump schemes using penny stocks. Prior to more robust regulation, many people lost their hard-earned retirement savings to shark “traders” that sold largely empty assets of fake companies. If you want to see a perfect example of this illustrated in cinema, Ben Affleck plays one such “stockbroker” in The Boiler Room.
3) Penny Stocks are for “Trading,” not “Long Term Growth Investing”
Finding a future high-growth penny stock is like finding a needle in a barn full of haystacks. The reason for this is simple: most penny stocks will remain as they are — penny stocks. Many will end up bankrupt and divested, which is why anyone who has investing experience will tell you to be extra careful when it comes to penny stocks. Very rarely should a person hold on to a penny stock, but that’s not to say that doing so can never be profitable.
Many professional investors use penny stocks for trading. Gains of a few cents can mean big profits when stocks are trading under $1 per share. If you buy 1000 shares of a 10-cent stock for $100 and it gains 4 cents in one day, you’ll earn $40 in profit. Imagine that scaled up. Now you understand why penny stocks draw new investors that use high-frequency trading techniques to obtain returns that are impossible to get from manual trading.
4) It’s Easier to Manipulate Penny Stocks
One of the dangers of investing in the stock market, especially in penny stocks, is the influence of prominent traders and influencers. An influx of interest in a stock is often prompted by influencers discussing the stock on the news. Then, the stock may plummet because the company didn’t have good fundamentals. The original buyers purchased low and sold after they pumped the stock. For most security exchanges, this influencer behavior is prohibited, and the penalties are steep, often involving jail time.
However, on over-the-counter (OTC) markets or “pink sheets,” where many penny stocks are traded, there is much less regulation. This is especially true for overseas securities.
Steps for Investing in Penny Stocks
Pick an Industry
Before buying any stock, you should research the industry you’re looking to invest in. Any time you look at a stock, read about what is happening in the sector. For example, if recent global events caused the market to make dramatic changes, find out which industries gained while others lost. There are many great tools to compare companies in different industries.
Penny stocks are harder to research as there is usually less information available about them. Also, because the markets they trade in aren’t heavily regulated, penny stocks aren’t required to release their financial information or important news. Many of them choose not to.
A good rule of thumb is to assume that if a company is not reporting any earnings, there likely aren’t any.
Choose a Broker (Online Trading Account)
So you’ve assessed the risks and want to try your hand at trading penny stocks. There are several ways to get started with trading stocks. Here’s a super brief rundown of how to assess various penny stock brokers:
You want to look at the fee structure. Is it per trade or per share? If you trade in smaller amounts, let’s say 100 shares at 10 cents, and a broker charges 8.95 per trade, you end up paying $17.90 for buying and selling. If the stock rises 2 cents and you make $12, you’re still not covering the commission fee. Most of the time, this fee is static. So, it’s better to use this kind of brokerage structure when you’re trading in larger amounts.
There are several ways that brokers structure fees. Robinhood is one example that charges $0 for trades but makes their money in other ways. It’s one of the better platforms out there. However, buying penny stocks on Robinhood has advantages and disadvantages, so you should read about how that brokerage works before making an account.
Most banks offer investment accounts and charge about $7-9 per trade. Banks make great brokerage accounts because of the wealth of information they provide. Plus, the fee to use their trading platform for this info is often built into your regular bank account’s fee.
Be cautious when reading about penny stocks online as information can be misleading. Reddit penny stocks, for example, are penny stocks discussed on the popular internet forum. Some stocks can get pumped up by this community. In early 2021, this happened when Reddit users found out that large hedge funds were short-selling penny stocks.
Be aware of these trends, but don’t be swayed by mass psychology. Making informed trading decisions means having all the facts and applying fundamental and technical analysis.
Stay Steady, Don’t Be Too Emotional, and Don’t Go All In
Warren Buffet said he believes emotional stability to be the primary defining trait of a successful long-term investor.
It’s important to note that penny stocks have not traditionally been good long-term growth investments. Penny stocks are fraught with peril and avoided for many of the reasons mentioned above. Still, that’s not to say that they don’t make any money.
Also, beware when you read things like “potential multibagger penny stock here.” Many people are lured by the promise of a fast return, but penny stocks are for incremental trading, not for buying all in and hoping it will explode.
Never put down more than you can afford on any stock, especially smallcaps and penny stocks. This should be common sense, but plenty of investors have lost everything. Do as much research as you can, and don’t buy into pure hype. Always try to utilize a mix of fundamental and technical analysis alongside professional help.
Featured Image: Twenty20