While I don't intend to discredit penny stocks or those who endorse them, I have reservations that I believe are crucial to share. It's essential to recognize that not all investment strategies carry the same level of risk, and penny stocks are no exception. They can be a risky venture, and it's essential to tread carefully.
It's crucial to understand that the popularity of penny stocks is not solely due to their potential returns. A significant factor is the lack of financial education among investors. This lack of knowledge often leads to misunderstanding the risks involved, making penny stocks seem attractive. By emphasizing the importance of financial education, we can empower investors to make informed decisions.
Let's delve into the concept of penny stocks. They're a type of common stock with unique characteristics that set them apart from other investments. “Penny stock” refers to shares traded at low prices, typically between $0.01 and $2.00. However, it's worth noting that some markets consider any stock trading up to $5.00 per share as a penny stock.
Penny stocks are a particular class of security that trades exclusively OTC "over the counter." They are also called pink sheets because of the original pink piece of paper on which the stock was printed in earlier days. OTC is a market for securities not listed on a formal exchange, and Pink Sheets traditionally uses a broker-dealer type of network to sell their stock.
Companies offering penny stocks have very small market capitalizations, few profits, and minimal operations. They are not listed on major exchanges because major markets won't permit them to be listed.
A pertinent question is why a company would become a penny stock. It's not accurate to label a penny stock as a distressed asset; however, a distressed asset can become a penny stock. Understanding these dynamics can help you navigate the world of penny stocks more effectively. Ford, Pier 1 Imports, Sirius XM radio, Kodak, Radio Shack, Monster Beverage, BlackBerry, Fanny Mae, and Freddie Mac, to name a few, are businesses that at one point slipped into the pink sheet category, are currently there, or don't exist anymore.
Listing requirements are another factor in why a company would transform into a penny stock. As it is, OTC is another avenue for a business that can go public but not on a major exchange, i.e., NYSE or NASDAQ. A traditional IPO requires a company to have a pre-tax income of $4.5 million in the previous year or $6.5 million over the past three years - a significant hurdle for smaller companies. By being traded OTC, companies can gather additional income until they meet significant exchange parameters, including the $500,000 NYSE listing cost - and $75,000 for a NASDAQ listing.
Lack of Available Information
In an industry where accurate information is paramount, penny stocks are notably deficient. Companies listed on the pink Sheets are operationally small, tightly held, and thinly traded. The concerning aspect of penny stock corporations is that they are not obligated to file annual or periodic reports with the Securities & Exchange Commission (SEC), such as a 10-K or a 10-Q. If a business has less than $10 million in assets, it's not required to submit a fiscal statement.
While financial data about penny stocks are becoming more readily available, SEC filings historically provide valuable financial information. They highlight a business's problem areas and decipher critical components when evaluating it as a potential investment. Without in-depth details - it's nearly impossible for an average investor to get accurate financial data.
Investors must also be cautious that industry analysts hardly cover these companies. Reading or watching financial media would indicate that information sources rarely cover companies not listed on major exchanges. This, in turn, requires more due diligence on the part of the investor to locate information that almost always ends up being a dead end. I'm not suggesting information can't be found, but data is often limited, fragmented, or mismanaged.
Pump and Dump Scam
Further, pink sheet businesses are unfortunately correlated with pump-and-dump scams. This type of securities fraud involves artificially inflating a stock's price through aggressive marketing and then selling off the stock at the inflated price, leaving unsuspecting investors with worthless shares. This shady tactic is one of the oldest forms of market manipulation and is a significant risk associated with penny stocks.
Pump-and-dump advertisements are often the stocks that financial Gurus, investing coaches, and infopreneurs push on their audience, masking fiscal inadequacies with stories of their financial gain. You see it all too often – pop-up video ads and newsletters with headlines that read, "This stock rose 10,000%, and our next pick will do even better - if you get in right now, you could be a millionaire.” It sounds like easy money, and it is easy money, but not for the ones being strung along.
Penny Stock advisors are also trying to sell their positions, with the price slowly accumulating over time until the scammer gets a signal to tank the stock. Unwitting investors buy into penny stocks with a sharply rising price, and the bottom is getting ready to fall out because there's nothing to keep the price up except for popularity and volume.
The Liquidity Issue
As new investors continue to join the world of investments, it’s important to remember one principle in the world of equity. Namely, for every stock buyer, there is a stock seller. This balance is known as 'Market liquidity.' In the case of penny stocks, the liquidity is often low, meaning there may not be enough buyers or sellers in the market, making it difficult to buy or sell penny stocks at the desired price.
Here's a potential issue: if someone desired to invest $50,000 or $100,000, it would be challenging to get their order filled without offering a price substantially above the current market. There aren't many sellers available waiting to dump their stock at a discount because there aren't enough shares outstanding at a low enough price point for people to buy.
And, of course, the opposite is true. Let's say you have the position of a seller. If you had built up a position worth $100,000 or more - you'd have to spend many days selling small blocks at a time unless you wanted to drive the price down exponentially. You couldn't put the entire block on the market for a much higher price - such as buying 0.10 a share and then selling it the same day to $0.25 per share – it’s unlikely that someone will step in and buy that position from you, given the dramatic price swing and risk.
As soon as you're in the money, you'll find it difficult to cash in, unlike blue chips, where there are always buyers and sellers. It's relatively easy for someone to come and tell you how excellent a particular penny stock is because they are probably holding that asset and looking for a way to liquidate their position.
In addition, if you purposely attempted to influence the share price by placing orders abusively, you could be caught by the Securities and Exchange Commission and face hefty fines that more than offset any potential gains you might eke out of the process and unsuspecting investors.
Penny stocks are almost exclusively used for rapid arbitrage opportunities because that's the name of the game, which makes them incredibly risky and easy to manipulate. Traders in these securities are always after the same thing - get in, get money, get out. The problem is that you're in a position where everyone thinks the exact thing, which has nothing to do with the company, its profitability, products, or services.
Traders in penny stock only focus on a few things: volume, moving average, popularity, and candle sticks. The stock line goes up; you sell - stock goes down, you buy.
Demand for Quick Gains Lifestyle
I attribute penny stock popularity to a few things, but one thing, in particular, is the willingness to forgo investing fundamentals for the opportunity for a quick buck. The hype for fast money is a specific type of drug that most penny holders are addicted to. Today, traders, especially penny stock traders, only use a few metrics within the technical analysis school of investing. This represents a fraction of all available tools for proper stock analysis.
It uses volume and momentum in a simple line graph of candle sticks. That's not a smart move because there's not enough information to go on, and the risk is exponentially higher than the reward.
Now, I'm not suggesting all penny stocks are nefarious pump-and-dump schemes or that all penny stockholders are bad people. As we speak, I'm currently holding penny stocks, but not in a capacity that would hurt me if the position bottoms out.
At the very least, you should work to understand that buying these securities has more in common with playing slot machines in Las Vegas. On average, you are more likely to lose significant amounts of money than you make any when trading, let alone trading penny stocks.
Speculative trading doesn't change the fact that you can be incredibly successful as an investor. People use the penny stock vehicle to get rich as fast as possible, which is counterintuitive to what you want to be doing when it comes to financial strategy.
The number one reason people buy penny stocks is the promise of a particular fast-love money lifestyle. Yet, I leave you guys with this - the reality is that there is no intelligent reason an investor needs to trade penny stocks or hold them in any portfolio. The risks are too significant to offset any perceived benefits.
I recommend choosing a strong and reliable financial strategy rather than a pink sheet perceived return on investment.
Instead, trading low-cost, small-cap index ETFs is a superior choice for many new investors who want a lot of exposure. Buy the significant dips in the market, swing trade blue chip companies, and trade a business that has been vested for a long time and is easy to understand.