Being relatively cheap compared to regular stocks and showing potential for quick gains, penny stocks are getting more and more attention from retail investors. This article is to explain the pitfalls of penny stocks and help you find the best microcaps for investing.
- Penny stocks are stocks priced below $5.
- They are not listed on traditional exchanges but traded over the counter (OTC).
- They are considered extremely risky assets due to their high volatility, lack of regulation, and low trading volume.
- Because of the lack of regulation, there are many fraud schemes associated with penny stocks.
- The vast majority of penny stocks don’t have the potential for growth.
- The most crucial thing to do for those who decide to invest in microcap stocks is to start with thorough research.
What are Penny Stocks?
Stocks that are not listed on traditional exchanges like the NYSE and NASDAQ are typically called penny stocks. Penny stocks are stocks of small public companies (small caps) with a market capitalization somewhere between $50 and $300 million. However, not all microcaps represent penny stocks.
Penny stocks are relatively cheap (typically less than $5) and traded in the decentralized brokerage systems, over the counter (OTC). People buy penny stocks mainly for the following reasons:
Low pricePenny shares are sold at low prices which allows investors to buy thousands of shares for relatively little money. The cheapest stocks are priced between 0.0001 and 0.0009 cents per share. The most expensive ones may reach $5.
High volatilityThis one may be listed in the disadvantage section. However, huge price swings typical for penny stocks make this instrument particularly popular among day traders. A price moving from $0.50 a share to $1.00 a share within a day makes a 100% gain. And such drastic price movements are normal for this type of asset.
Hopes for the future growthRemember that part in Forrest Gump movie where Forrest receives a letter from a "fruit company" called Apple, saying that he doesn’t have to worry about money anymore? It perfectly illustrates the motives for buying penny stocks. The prospect of gaining shares of a soon-to-be unicorn lures crowds of people into buying them every day. And small companies do grow into giants occasionally. Let’s not forget that Amazon and Apple once have been small caps too.
On the other hand, penny stocks have a few disadvantages, which contribute to the general image as being a "too risky investment". The drawbacks include:
Lack of informationCompanies listed on major exchanges have to comply with the exchanges’ requirements which includes the reveal of financial data. Conversely, microcaps traded OTC, don’t have to do any of it. Some of them provide too little information for public analysis. It means that you never know what you’re buying when purchasing penny stocks.
Low trading volumeSuppose your stock rises from $0.50 to $1.00 a share. To sell it at the desired price, you will need a buyer but there are few of them in the market. While NASDAQ and the NYSE have a lot of buyers ready to purchase at any time, it might be hard to short penny stocks when the right time comes.
ScamsMicrocap stocks are often associated with "pump and dump" fraud schemes. The scummers buy large quantities of stock and drive up the share price using high-pressure sales tactics. As soon as the price rises, they sell off their shares at increased prices, leaving the rest of the shareholders with worthless assets. Obviously, not all penny stocks are scams. Yet, you should be vigilant when going for this type of investment.
Poor prospectsThe majority of penny stocks will never grow in price. This is what history teaches us. Definitely, there are examples of growth. However, companies like Amazon and Apple are rather the exceptions than the rule. Trying to guess which company will soar in the future is somewhat close to buying a lottery ticket.
Trading conditionsA few brokers allow trading penny stocks, although the commission rates for trading them frequently turn out to be higher. It means that even if you manage to sell the asset at the desired price, part of your profit will be lost after the fee reduction.
If you are still hesitant about whether you should buy microcaps, why not consider a few alternative options? Before risking any of your money with penny stocks, learn about the alternatives below.
Same as penny stocks, foreign exchange (forex) allows trading with little money, which makes it a good alternative for those who think about microcap stocks in terms of day trading. Currencies are highly volatile, which allows traders to make a good profit from the intraday trades. The difference though is that forex is a far more liquid market, and closing a position in no time won’t be an issue there. Plus, currency doesn’t necessarily have to grow to bring profit. Currencies are always traded in pairs. Because of it, traders can earn from short positions as well.
Thanks to online brokerages, shares of reputable public companies have become more accessible to people who do not want to invest a lot of money. For as little as $5 one can buy a fractional share, which represents a "slice" of stock. Suppose a company's stock is selling at $800 a share and you buy $200 worth of it. What you get is 0.25 (25%) of a share. Compared to penny shares, you get shares of a trustworthy company that meets the requirements of a reputable exchange and is obliged to report on its financial performance. You can buy fractional shares through investing apps or online brokerages.
A contract for difference (CFD) is a contract between two individuals referred to as "buyer" and "seller", stipulating that the buyer must pay the seller the difference between the current price of an asset and its price at contract time. Conversely, the seller must pay the difference to a buyer if the price difference is negative. CFDs require smaller financial investments as they don’t involve the actual purchase of an asset.
How to Buy Penny Stocks
As it has been stated before, investing in penny stocks has more cons than pros. If our arguments haven’t convinced you and you still want to buy penny stocks, read a few recommendations below.
Two initial steps you should take are determining the amount of money you are ready to invest and choosing penny stocks. As for the size of the investment, don’t spend more than you are ok to lose. This is the rule for any financial venture, especially this one.
Picking the right stock must involve extensive research. You can look for companies on major exchanges that have dropped below $5. Although these "fallen angels" aren’t considered typical penny stocks, they provide more security than the stocks traded over the counter.
And lastly, read everything about the company you are buying. This advice works for any kind of stock, especially for penny stocks. How to research penny stocks? Check sources beyond Pink Sheets and the Over the Counter Bulletin Board to find info on the asset you are interested in.
Where to Buy Penny Stocks
If you don’t know where to trade penny stocks, there is good news for you. Buying this instrument is relatively easy through various online brokerages. Check a few to find the most convenient trading platform and the best trading conditions with minimal fees.
Finding a penny stock with profit potential is extremely difficult. Due to a lack of regulation in the OTC market, this type of investment is susceptible to fraud. There is a joke that says gambling is less risky than investing in microcaps. If you decide to buy OTC stocks, make sure you do thorough research and buy them through a reliable online brokerage. But before that, consider alternatives.
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