Penny Stocks for novice investors are incredibly enticing. They move fast, have a low price point, and offer the illusion of easy money. This however is anything but the truth. Unless you know exactly what you are doing then you should avoid penny stocks and stick to stable assets.
The top 5 reasons why you should avoid penny stocks are; low liquidity, manipulative tactics, high risk, better opportunities elsewhere, and regulation risks.
By learning the pitfalls of penny stocks you can better arm yourself to either trade them or invest in other sections of the market. Here at Chronohistoria we aim to help investors make the most return in the market as possible. We don’t touch upon penny stocks because they are not a good investment.
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Without further ado, let’s first define penny stocks and then jump right into the top 5 reasons why you should avoid penny stocks.
Quick Definition of a Penny Stock
Generally speaking a penny stock is any stock that trades below a $5 price point. Penny stocks typically have huge swings as they are designed from the beginning to have very little shares publicly available to the market.
This is called a stocks float, and if you check your favorite penny stock then chances are it has a float under 75 million. This means that the stock can ‘run’ very fast. Now couple this low float with a low price point and now everyone can buy 100 or 200 shares, thus massively increasing volatility in the stock.
This is the reason why penny stocks can move so fast. It’s the combination of the low float and the high volume.
Reason 1: Low Liquidity
There is a popular belief that you can throw $1,000 into a penny stock and double it overnight. This simply is not the case. This is because oftentimes novice investors wont factor liquidity potential into their investing decision.
Liquidity is the ability for you to ‘liquefy’ your shares back into money. If a stock has a high liquidity then you can easily turn your investment back into cash at a moment’s notice. If you’re in a stock with low liquidity then you won’t be able to recover your investment even if you wanted to.
So how do you quickly gauge liquidity in a stock? The fastest way that analysts on the street do it is by taking the average daily volume on a stock and only investing 10% of that. That way they can easily get out of the investment if it starts going against them.
So let’s look at a large-cap stock to see the liquidity potential. Taking 10% of AAPL’s daily average volume of 3 million shares nets you 300,000 shares that you can trade. Now 300,000 shares of AAPL at AAPL’s current price ($149) means you can invest at max $44 million without running into liquidity problems on the investment.
Here is the formula for maximum investment due to liquidity:
Maximum Investment = (Average Daily Volume * 0.1) * Current share price
Apply this calculation to your favorite penny stock and you will find that suddenly you can only invest $100 or less at maximum due to liquidity risk. This is a major killer of all novice retail investors. They simply don’t factor liquidity into their investment decisions and become something called bag holders.
Before you invest/trade penny stocks always calculate liquidity to see if it’s even worth your time to invest.
Reason 2: Manipulative Tactics
There are two major manipulative tactics in penny stocks; Pump and Dumps and Stock ‘Gurus.’
Both of these manipulative tactics seek to convince novice retail traders to buy into a stock so that they can make a quick buck. They don’t have your best interest at heart. I am going to go over both of these so that hopefully you can learn to avoid them.
Pump and Dumps
A Pump and Dump is when the company of the penny stock will put out several reports in a small time frame and then dump their corporate holdings or have friends/satellite investors dump the holdings for them.
Pump and Dumps are highly illegal if done ‘purposely’ and are trackable by a regulating government entity such as the SEC.
Once you know what you are looking for, spotting these pump and dumps becomes extremely easy. Oftentimes the company will announce that they are going to be selling more shares on the market and then a couple weeks later the company will announce positive news. Investors will then clamor in and the company will sell into this ‘pump.’ The final step is to then let the stock fall, aka the ‘dump.’
Here is an example of this.
If you were to buy into this company off the ‘great news’ then chances are you would be left holding the bags. Because the above company announced they were going to be selling shares earlier in the month, it’s not an illegal pump and dump, because they alerted shareholders they were going to do this….
It would be illegal if the company allowed their executives to sell shares without notifying the public or if the company ‘gave’ their shares to another company/person to sell on their behalf.
Pump and Dumps are a common thing with penny stocks. It’s a way for a company to get rich quick off the back of investors. Don’t fall for it.
Ok, so I know you have seen these guys. They have ads on YouTube and can be found on Twitter.
A stock ‘guru’ is someone who touts their success rate in trading stocks. They offer premium chat rooms, stock picks, or educational material for trading.
Often you will find the stock ‘guru’ advertising their lifestyle. They will show fancy cars, clothes, and travels. They offer the lifestyle that everyone wants. The problem however is that it’s all a lie.
Stock Guru’s make their money off selling products or services that convince retail traders they can make a quick buck off their knowledge. They will go to substantial length’s to promote their material.
The problem is that what they are promoting convinces people that trading is better than investing and that the average retail trader will become rich. This is a flat out lie.
What happens is that a stock guru will take a position in stock and then market the stock to their followers who will then buy the stock and drive up the price. The guru who bought in before everyone will sell out into this retail trader hype and make out like a bandit.
You need to be incredibly careful on who you follow or listen to when it comes to investing. Out of the hundreds of ‘professional’ traders I have met I would say that less than 1% of them actually trade for a living and they do not have a following on Twitter.
The rule of thumb is that if the stock ‘guru’ is recommending trading they are generally fake, if they are recommending investing then chances are they know what they are doing.
The reason behind this logic is simple. A professional investor has a repeatable investing methodology that can be back tested and logged. The professional trader often does not.
Avoid stock gurus.
Reason 3: High Risk
This goes without saying. Penny Stocks are incredibly risky investments.
As we can see from the above image if we are aiming for a 5% investment gain per year we have around a 2.5% chance to lose money in our portfolio. This risk to lose money increases exponentially as you pursue gain.
Investing in a penny stock and trying to make a 1,000% return overnight has close to a 100% risk. Simply explained you have a near 100% chance of losing money if you’re pursuing penny stocks.
Risk is a silent killer in portfolios. Professional investors are in the business to reduce risk, not increase gain. The name of the game is risking less to return more.
Normally to reduce risk professional investors will hedge their investments. Typically this involves strategic option contracts or arbitrage trading. With penny stocks you can’t do this. You are essentially naked to risk.
Penny stocks have inherent risk in them. This is because they are penny stocks, if they were ‘safer’ investments the market would price them higher naturally and they would no longer be penny stocks.
It’s better to go after established companies that can get you a stable return. Your money will be there tomorrow and even grow.
Reason 4: Better Opportunities Elsewhere
Ok, so you want to double your investment overnight. Believe it or not, penny stocks are not the way to go.
For example, you would have a better chance at making money by buying option call contracts near an earnings report. Yes this requires learning about options but a little bit of studying can net you huge returns if done properly.
Or you could simply invest in crypto currency instead. You are already risking 100% of your investment, might as well give yourself more economic opportunity. Over the past decade crypto currency has exploded and if you had invested properly you could have turned $1,000 into $100 million within a decade….
I personally hold about 10% of my overall portfolio in crypto. I have been holding a combination of BTC, ETH, and ADA for about three years. It has far outstripped my normal investment returns and continues to do so.
If you’re interested in a research article on Crypto and how to position yourself for massive gains check out the following article.
So ask yourself why put 100% of your investment at risk to only make a fraction of what you could? If you’re going to risk it for the biscuit might as well go all the way.
Reason 5: Regulation Risks
Ok, in order for a stock to be publicly traded it needs to meet certain standards. This is to protect the market from being flooded with a million companies who are valued at $20.
For example on the U.S market a stock must have a market cap value of $400,000 and have a stock price above $0.10 in order to remain in regulation and be listed for public trading. (Source)
When you invest in a penny stock you are a hair away from having your investment ‘delisted’ or put into the grey market. This means that you can’t sell your shares to anyone on a public market but instead must find a buyer for your shares and personally transfer them.
Take it from someone who personally has 10,000 shares of a delisted company, it sucks to not be able to sell your shares. It’s important to prevent yourself from falling into this trap by investing in penny stocks.
A penny stock is close to being delisted. If their stock price should fall then chances are you would lose 100% of your investment. Some penny stocks do this on purpose after selling their shares to the market. It’s a way for them to make a quick buck and then lose their valuation status. In essence this strategy prevents investors from selling their shares back to the market and gets the company several million dollars.
Avoiding penny stocks is a great recommendation for novice retail traders. It’s better to start with trading the larger companies so that you can learn the tricks of the trade and not lose much money while you do it.
I never trade penny stocks. There just is not a reason for me to do it. I get better returns elsewhere with less risk. You can too, I put pretty much everything I invest in up on this site and help people generate wealth in the markets.
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Further, you can check out some other articles below.
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Why You Still Own a Stock After It’s Delisted and How to Sell It
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Can You Make 1% A Day in the Stock Market? (3 Steps)
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Until next time, I wish you the best of luck in your investments.