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What are penny stocks and why are so many investors and traders new to the stock market drawn to them?
This article will break down what penny stocks are for beginners, the truth behind these companies and what I believe to be the smarter way to profit from these penny stocks as a small time day trader and investor.
Intro to Penny Stocks
We all know that investing in shares of a stock means you are owning small percentage stakes of established companies like Apple(AAPL), which has a market cap of 900 billion. Market cap refers to the total dollar value of a company’s outstanding shares. It’s used by investors to determine a company’s size.
Penny stocks are companies with a much smaller market cap than our example of Apple. Generally speaking, penny stocks are companies with a market cap less than $300 million (micro caps), with some being even less than $50M (nano cap).
Definitions vary, but the Securities Exchange Commission (SEC) classifies penny stocks as companies traded under $5. Many of them, if maintained above $1, are still traded on the Nasdaq or the NYSE, the regulated stock exchanges.
However, the true penny stocks are companies traded below $1. These are what we call pink sheet stocks, which are the companies Jordan Belfort pumped in the movie The Wolf of Wall Street. They are traded on Over the Counter Bulletin Boards (OTCBB). That seems all fine, but penny stocks do carry some element of risk.
Why are these penny stocks considered risky?
1. A lack of information available to the public
The first and the biggest reason is thelack of information available to the public. This really only applies to the OTC penny stocks traded under $1. Companies listed on the pink sheet are not regulated by the SEC and are not required to make financial documents available to their investors. Without these documentations such as the 10K, investors cannot find out their cash flow, operating expenses and whether or not these companies are actually generating revenue.
As for the small cap penny stocks trading above $1 that are listed on the Nasdaq and NYSE, these companies are required by the SEC to file their financial statements, register for offerings and inform investors of important updates. In that sense, the penny stocks above $1 are a little less risky than the true penny stocks on OTCBB.
2. Misinformation and Pump and Dumps
The second big reason penny stocks of all prices are considered risky is because they are still sketchy and easily manipulated through misinformation and pump and dumps.
Many of these penny stock companies release news and pay promoters to pump their share prices up with sensational headlines, which have been talked about in many of my penny stock videos. These penny stock news releases often include keywords in the titles such as “agreements”, “contracts”, “advancement”, “strategic placement” etc.
These are what I call sensational key words because these sketchy penny stock companies take advantage of the fact that most investors and traders in the market are lazy and don’t read past the headlines. If you actually dive into reading and analyzing the entire PR articles like I have done in some videos, you’ll see that most of the time, the content is really all fluff and shows no real promise in the company’s potential earnings.
Of course, the purpose of these PR pumps is to drive shares prices up hundreds of percent as has been seen in examples like $OPTT, $BPTH, $YRIV and $ABIO. As the share is hiked up, insiders of these penny stock companies start to sell and dump millions of their own shares on unsuspecting investors. Sometimes these penny stock companies will take advantage of the pumped up share prices to issue offerings and raise more money for their companies.
“Legal” Pump and Dumps
We’ve seen examples of these pump and dumps with OTC stocks. These penny stock companies recruit third party online promoters to send out promo emails and publish false articles.
While many will argue that the NASDAQ penny stocks are regulated and less manipulated than the OTC penny stocks, the truth is these sensational press releases are what’s considered “legal” pump and dumps.
This practice starts treading into a real gray area because even though it is very manipulative, it is indeed legal, in the eyes of the SEC, to release exciting news about the company to investors.
There have been some extreme NASDAQ penny stock manipulation cases like $LFIN and $HUNT. Both of these companies released misleading news to drive their share prices up from under $10 to around $100, which is basically a 1000% ROI scheme. Both of these companies were investigated by the SEC and delisted from the NASDAQ stock exchange to OTCBB.
Let’s be real here, though. These two companies being delisted only represent less than 1% of all the penny stock pump and dump schemes in the market. Unless it’s really blatant insider trading or manipulation like the $LFIN and $HUNT stocks, these PR pump and dumps from small cap penny stock companies are really just everyday activities in the stock market. I just want to raise awareness for new traders and investors because it is something that happens.
Penny stocks are inherently risky investments. It’s safer to always be skeptical of penny stock promotions, PR releases, and penny stock chat room recommendations, so always do your own due diligence on the company.
Penny Stock Misconceptions
While I do think some penny stocks can provide great profit opportunities for day trading and swing trading, I would AVOID investing in penny stocks all together unless you have real inside information about the company.
Two very common misconceptions about penny stock investing is that many of today’s big companies like Apple and Amazon(AMZN) were once penny stocks themselves, and that if an investor can buy into the investment at 20¢ a share today, then he or she can make a fast 100% if the stock runs to 40¢ tomorrow.
Both of these misconceptions are not fully true at all. We must remember the single purpose why private companies choose to go public. Companies go public and sell their stock shares to investors in order to raise money, to fund their research and potentially develop products to sell.
Stocks are not listed to make investors money; that’s not the priority anyways. They’re there to move capital from your pockets to the company’s bank accounts. If the companies are truly profitable and legit, then their stocks will rise in prices and make investors money.
Reality of the Situation
That is only true for profitable companies with real products like Apple. The reality is most penny stocks are actually losing money and do not have real products at all. Instead, they just keep on selling their shares to investors and raise more cash to operate and pay their board members until they one day go bankrupt. In those unfortunate cases, the penny stock investors lose 100% of their investments, and the insiders walk away clean with their salaries and bonuses, paid for by the investors of course.
While it is true the price fluctuations of some penny stocks from 20¢ one day to 40¢ the next could potentially make some investors 100% ROI, what most people fail to see is the downside. The price of the penny stock could just as easily drop to 5¢ the day after, in which case, the investors lose 75% of their money in just two days.
Very often when these penny stocks get delisted from the NASDAQ exchange to OTC, their share prices just keep on dropping and dropping due to offerings, dilutions etc. Therefore, it’s not uncommon to see investors lose basically everything in penny stocks.
Can money be Made From Penny Stock Trading?
There is definitely a lot of money to be made in penny stock day trading and swing trading. However, that means you would just be buying and selling penny stocks intraday or within a short few days instead of over the course of months or years.
Every once in a while, there are penny stock companies on the OTC that have worked very hard, have shown impressive growth and finally met the requirements to make their stocks available on the Nasdaq or the NYSE. A perfect example of that is a marijuana stock called Aurora Cannabis ($ACB). Their stock shares were listed on the OTC pink sheets as $ACBFF until October of 2018. However, the chances of most penny stocks growing their business to be like Aurora Cannabis is extremely low.
Instead of investing your hard earned money into penny stocks, the wiser long term decisions would be to invest in established companies such as Apple, Facebook(FB) and Disney(DIS). Sure, you may not be able to own as many shares as if you were to buy penny stocks trading at $1, but the long term percentage growth of established companies is undeniable. These investments are much safer as well.
Investing or trading any securities involves risk. Before throwing your money into just any penny stocks, make sure to do your own research and establish your own risk reward profile. Always be skeptical of PR releases and do not follow others’ alerts.
Disclaimer
This article is not financial advice to buy or sell any stocks and is only meant to inform you about the potential risk involved with penny stocks as well as the upside if you learn to day trade or swing trade them correctly.
Don’t feel like reading? Watch the video.
