---
title: "Risks of Penny Stock Trading"
description: "Thinking of trading penny stocks? You can lose a lot of money. Here's why that's risky!"
canonical_url: https://trendshare.org/how-to-invest/risks-of-penny-stock-trading
markdown_url: https://trendshare.org/ai/risks-of-penny-stock-trading.md
published: 2014-01-09
last_updated: 2020-06-17
content_license: https://trendshare.org/about/disclaimer
---
# Risks of Penny Stock Trading

Source: https://trendshare.org/how-to-invest/risks-of-penny-stock-trading
Updated: 2020-06-17
The adage "buy low, sell high" is good advice, but "buy low" doesn't mean
"buy the cheapest stocks possible". Similarly "sell high" doesn't mean "wait
for it to become the most expensive stock possible". Low and high are relative
terms: buy when it's undervalued and sell (if you must) when it's
overvalued.

Novice investors commonly look for extremely cheap stocks, figuring that a
stock selling for $1 has a lot more [room to double or quadruple](https://trendshare.org/how-to-invest/what-is-a-tenbagger-stock) than a stick which sells for $10. Novices commonly fall
into the trap of looking for things called "penny stocks"—and this can be
a trap.

## Penny Stock Trading

A penny stock is generally a stock that:

- Is worth less than $5 a share

- Trades outside of a major stock exchange (like the NYSE, NASDAQ, or Chicago Stock Exchange)

- Represents a company in some form of financial trouble

These stocks are cheap for a reason: they usually belong to companies in
bankruptcy or other financial troubles. These stocks are popular in certain
circles, but they're very risky. You might also hear them referred to as
*microcap stocks* or *pink sheet stocks*. It's all the same
thing. See the [SEC's penny stock rules](https://www.sec.gov/fast-answers/answerspennyhtm.html) for more detail (warning; regulatory language).

Trading these stocks is a risky investment strategy that relies on big
percentage movements for stocks selling for small amounts. For example, a stock
that sells for $0.30 a share can make you a 25% profit if the price jumps
suddenly to $0.40 a share.

That's a big *if*!

Because these stocks are sold over the counter, you can't buy and sell them
as easily as you would a "normal" stock. You can buy or sell them through an
online broker, however—if you're willing to take on the risk. Buying can
be pretty easy, but selling is often more difficult. You have to find a willing
buyer for the price.  Hold that thought in your mind for a moment.

## Stock Prices Represent Value

Cheap stocks may seem like a good value for your money. If you have a
thousand dollars, you can buy 7 shares of [Boeing](/stocks/BA/view)
at $140 and 2000 shares of some random stock selling for $0.50. Which would you
rather have, seven shares or two thousand?

It seems like it's easier for something selling for fifty cents to go up to
a $1 (doubling your money) than it is for Boeing to go up to $280 (also
doubling your money).

That math doesn't quite work out, because the *value* of a stock
depends on two things.  First, its value is whatever someone's willing to pay
for it. With millions of shares changing hands every day, millions of people
are judging what stocks are worth. Second, the value of a stock depends on the
value of the business behind it. It's much better to [own a company that's making money](https://trendshare.org/how-to-invest/earnings-matter-most) than it is a
company that's losing money. People are willing to pay a little more for the
privilege of owning part of a successful business than they are to own part of
a failing business.

Most of the time, a stock price below a dollar means that people think the
business is in trouble. Most of the time, they're right. Sometimes the cheapest
stock to buy may be the most expensive stock to own—when you can't sell
it for what you paid for it.

## Risky Companies Can Go Bankrupt

[In November 2011, American Airlines filed for bankruptcy](http://www.aa.com/i18n/amrcorp/newsroom/fp_restructuring.jsp). Its stock dropped to
pennies per share. "What a bargain," you might think. "For pennies per share
you get an airline, airplanes, fuel options, flight plans, pilot contracts, and
more!" Eventually American Airlines merged with US Airways and the resulting
entity left the penny stock behind and returned to a major exchange.

That's one success story out of countless failures. Keep in mind that one
share of AAMRQ you bought at $0.25 doesn't necessarily equate to one share of
the new [AAL](/stocks/AAL/view) at $30. In bankruptcy, anyone with a
claim on the assets of the bankrupt entity gets to negotiate on the terms of
their payment. As the holder of a share of *common stock* (if you don't
know what that means, you're definitely a holder of common stock) you're at the
lowest place on the list. You have almost no say in what happens to the
business's assets.

If the company is in so much financial trouble that there's no chance it'll
be able to pay off its debts, it may have to be broken up and have all of its
assets sold off to its creditors. You're not getting any money out of that.
You're not making 120x returns. Those 400 shares you bought at $0.25 per share
are worthless and you've lost all that money. That happens sometimes.

## Struggling Companies and Buyouts May be Profitable

American Airlines didn't go out of business. Instead it merged with another
company. Sometimes that happens, or sometimes a stock gets bought out entirely
(as was the case with [Orchard Hardware](http://www.osh.com/), which
[Lowe's](/stocks/LOW/view) bought in late 2013). In that case, the
acquiring company will often make a bid for the troubled company, based on what
they think the company is really worth. That's *probably* the value of
the assets: real estate, inventory, existing contracts minus existing
liabilities.

In the case of an acquisition, the acquiring company may either pay existing
stockholders a fixed price per share or convert shares of the acquired stock
into shares of the new parent company at some ratio. (In other words, you might
get one share of AAL for every forty shares of American Airlines you held.)

Sometimes this is a good deal. Sometimes it's a fair deal. Any profit you
make depends on the price you paid. If it's below the acquisition price, you
might make a little profit. Timing is everything; you'll only make a profit if
you paid less than you're getting in return.

How do you know what an acquired company will sell for? You have to figure
out what the company as a whole is worth—its inventory, any existing
contracts, any investments, the value of real estate, and the opportunity costs
of acquisition. That's a lot of financial analysis for a company that'll
probably go bankrupt.

## Selling Penny Stocks is Difficult!

Of course, to *buy* a stock at the right price, you have to find
someone to *sell* it to you at that price. That's not easy. Unlike a
normal stock, where people buy and sell based on actual value of what the
company can actually make, penny stock trading relies almost solely on
speculation. Everyone who owns the stock is waiting for it to turn around
somehow. Maybe you'll get lucky and someone who bought it for $0.20 a share is
willing to unload a few thousand shares at $0.25 a share, but it's more likely
that anyone who bought it wants to make 10 or 20 or 50 times profits.

The same goes for getting out of a stock. Sure, you bought it at $0.25 a
share and good news has raised it to $0.50 a share, and you think you're as
lucky as you're ever going to get, but are there enough buyers at $0.50 a share
for you to sell all of your shares?

Penny stocks have very little [liquidity](https://trendshare.org/how-to-invest/what-is-liquidity).
There aren't many buyers and sellers *because* they're so risky. Unlike
a share of [Coca-Cola stock](/stocks/KO/view) you can buy or sell
pretty much anytime near the asking price, there aren't enough buyers and
sellers who agree on prices, so their prices have wild swings. You're going to
have to have great timing and even better luck to sell at the price you had in
mind. That's *after* you've gone through all of the hoops in [buying these shares in the first place](https://trendshare.org/how-to-invest/should-you-buy-penny-stocks#buying).

Sure, you can wait for the company to turn around—but most don't. Most
don't get acquired. Most go out of business.

Day trading penny stocks will be frustrating when that lack of liquidity
works against you. If you're at all ethical—if you're not defrauding
other people with pump and dump scams—you're relying on luck, and
*luck is a poor investment strategy*.

Patience will work against you. You have to race around the clock before
these poor companies go out of business altogether. That hot tip you saw in an
email or on Facebook or Twitter is someone's desperation trying to trick you
into buying what they really want to sell.

You can generally buy microcaps through any [reputable stock broker](https://trendshare.org/how-to-invest/what-is-a-discount-stock-broker), though
you'll likely have to sign a disclaimer that you understand the risk of
smallcap trading. In shadier corners of the Internet, you can find businesses
which purport to specialize in these trades, but trust may be an issue. Any
reputable stock broker will have to run you through several pieces of paperwork
to ensure that you understand the risks of this type of investing.

## Is Trading Cheap Stocks Worth It?

Before you hit the buy button on your amazing bargain trade, keep in mind
several risks!

It's difficult to buy and sell penny stocks for good prices. You don't even
know what the right price is or the right price will be. You're competing with
a lot of other people trying to outsmart each other. It's very difficult to
find the fair valuation of a business in financial trouble, so you will have to
do a lot of work to figure out the right price to pay.

Turning around a troubled company takes time. Good returns are rare, and
they're smaller than you might think. Turning a company losing millions of
dollars a year into a company making millions is a lot of work!

If you buy, you'll become a creditor probably last in line for
liquidation, so if everything goes wrong and the stock goes out of business,
you might lose all of your money (or get ten cents on the dollar).

Finally, many of the people promoting these stocks are *really*
making money from convincing you to subscribe to a penny stocks newsletter. If
there's a really great underpriced stock, would you want other people to swoop
in and buy it and drive up the price? Maybe—if you want to sell it to
them at inflated prices!

## Characteristics of Good (and Undervalued) Stocks

Troubled-but-good stocks are out there for the taking. They all have several
characteristics:

- **They represent companies with real assets**, so there's business value in the companies themselves.

- **They have a well understood business plan**, so there's a path to making money in the future.

- **They have a strong market liquidity**, so you can buy and sell without too much hassle or time.

- **They have a plan to turn things around**, whether through an acquisition, bailout, or improved business conditions.

The latter is the most important; there's no point in buying a stock that's
about to go out of business.

Investing well means time and patience, looking for true value and buying
good businesses. You never need to pay anything besides discount broker
commissions. No secretive broker will help you get wealthy with cheap stocks.

Successful investors aren't day trading penny stocks. No hot cheap stock
lets you make incredible money in a week; anyone who tells you otherwise is
gambling that they can fool you.