Do cheap stocks increase your ability to make money trading stocks online? Penny stocks are risky. Reduce your risk!
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During the coronavirus pandemic of 2020, a lot of new traders entered the market, looking to make money online trading stocks. Articles and ads about new self made millionaires popped up.
If you're in that group, read carefully before you fall into a subtle trap!
New investors often see stocks with low prices and think cheap is good. After all, a stock worth $1 per share only has to gain $1 to double your money, while one worth $100 per share has to gain $100 to double your money.
The math is true if it works, but it's misleading. The secret of making money in the stock market is patience. See, for example, Peter Lynch's One Up on Wall Street or John Bogle's The Little Book of Common Sense Investing for more details.
If you believe the hype all over the Internet, penny stocks make quick money for savvy investors. Unfortunately, you're not likely to get rich here. You're more likely to lose money.
Most of the time, penny stocks aren't worth the risks. Penny stocks—also called micro-caps or small caps—aren't like normal stocks. They're not listed on any major stock exchange. Even if you have a good online broker, you may have to jump through hoops to buy them, even signing a waiver with your broker.
Where Do Penny Stocks Trade?
Unlike normal stocks listed on the NASDAQ, New York Stock Exchange, or other major markets, penny stocks are traded on the OTC (Over The Counter) markets.
Why does this matter? Two reasons: the ease with which you can place trades and the quality of information you can get about the company.
With an online broker, the first reasons is rarely a problem. You can buy from any exchange your broker supports.
The second reason is more seriously. Pay close attention to where a penny stock trades. If it's on the OTCBB (operated by the Financial Industry Regulatory Authority), the company has met at least the minimum standards of keeping its financial statements up to date. If it's on the Pink Sheets, it may not have met even those requirements.
Pink Sheet stocks don't have to provide reliable financial information. All you can do is guess what's going to happen. The more data you have and the more accurate it is, the more smarter your financial decisions can be.
What Happens When Exchange-Listed Stocks are Cheap?
Not all low-priced stocks are penny stocks, even if their prices are low. If Ford Motor Company suddenly dropped to 50 cents per share, that wouldn't necessarily make the company a penny stock company. (It could have executed an aggressive stock split, for example.) As long as Ford continues to meet the standards of the exchange, it's not a penny stock.
This cachet from association is one of the benefits of being listed on an exchange.
The NYSE and NASDAQ, for example, have requirements on a minimum market cap and share price, as well as annual listing fees. When a stock dips below the point where its capitalization or the price per share is too low to meet those standards, a market may delist the stock or remove it from the exchange. In that case, the stock tends to move to an OTC market.
If you own shares of a company that gets delisted, you still own those shares. (They're not worth as much, but you still own those shares.)
Which Cheap Stocks are Good Stocks?
Finding a good company to buy means looking for a bargain business that can turn things around. What makes a penny stock a good stock? Several characteristics:
- The company must actually make money. A company that loses money is a bad investment. You might as well sell everything off and invest in another business.
- The company needs substantial assets or generate enough cash. If the creditors get antsy, a strong business won't have to liquidate its future viability to pay them off. Measure this with the current ratio, for example.
- The company must have and execute a strategic plan. Part of this is getting big and strong enough to get re-listed on a major exchange. Paying back investors (especially stock speculators!) is one thing, but the goal should be to rebuild a long-term business.
All three factors reduce the risk of investing. Great penny stocks may truly exist, but the odds are against them. These businesses are struggling and provide below-average financial performance. What makes you believe they'll provide above-average returns?
That's not a rhetorical question. These stocks have high risks. What information do you have that shows the likelihood they'll overcome these risks?
Where do People Find Penny Stocks?
A lot of hot stock tips for blockbuster deals end up being penny stocks. This should be a warning sign. Stocks everybody wants to own don't have bargain basement prices.
Obscurity works against you. You want to find an undervalued stock. It needs to have a positive value: good financials and an improving outlook. It also must be overlooked, flying under the radar of most investors.
For you to buy a stock, someone must be willing to sell it to you at that bargain price. If the company's really going to turn around, why not hold onto it until it gets more attention? Maybe you can luck out and find someone willing to sell a lot of shares at a fire sale price.
Worse yet, after you've found that bargain basement price and you've bought a great penny stock with potential, you'll eventually have to sell it. Maybe you can hold onto it until it's popular again, but it's unpopular right now for a reason. People aren't looking at it. People don't want to buy it. How are you going to unload it?
Your best hope is to hold it until the company completely turns around and gets back on a normal stock market listing again. That can happen—but the risks are high.
Money-Making Penny Stock Strategies that Work
Penny stocks can make you money in three ways. None of them are easy; none of them are guaranteed. It's safer and easier to build wealth with value investing, but you must be patient: first to find good opportunities and then to wait for the results.
Pump and Dump
Buy cheap, talk up, sell high. The most popular way to profit from a penny stock is to buy it cheap, convince other people that it's worth more than you paid for it, then sell it at the inflated price. This is hugely unethical and likely illegal. It's also difficult to make work.
You've probably received spam email telling you about this great hot tip promising "top penny stocks for 2020". The price is about to explode! You'd better buy it now to lock in your profit! Think about that for a second.
Any stock that increases in value does so for a reason. Perhaps the underlying business has improved. Perhaps the company's about to be acquired. Perhaps they've just landed a huge exclusive offer. If any of this is true, it raises two questions. First, why would anyone encourage more people to buy the stock? More buyers means the price will go up. Second, how does that person know the price will go up? (At least without falling afoul of insider trading laws.)
It's a safe bet that your anonymous friend bought shares at 25 cents and wants to sell at 50 cents and is trying to pump up excitement to attract more buyers and drive up the price. Nothing about the business has changed; it's still worth 25 cents per share. Your friend doesn't want to help you. Your friend won't teach you how to invest in penny stocks and make money. Your friend is looking for suckers to buy the stocks they want to sell to make money fast. You're being manipulated.
The goal is to pump up allure, not to turn around the business with savvy decisions and time.
Penny stocks themselves aren't illegal, but this scheme can be.
Buy cheap, wait until you get lucky, sell. An ethical investor would prefer to to buy the stock of a valuable company and hold onto it until the price reaches a good sales point. Unfortunately, you can't predict luck. There's no simple way to find a list of all of the good, cheap stocks to invest in. Not all good stocks are cheap and not all cheap stocks are good: a battered and bruised company could easily go out of business and sell off everything to creditors, only to pay you a fraction of what you put into the stock.
Struggling companies can turn around, but a struggling company is struggling for a reason, and its stock price will reflect that. At least in Las Vegas or Atlantic City, you know the odds of winning before you put down your money. Penny stocks offer no such guarantee. (Unlike a casino, you won't end up owing money in the stock market unless you chase more exotic investments like futures, options, and derivatives.)
Find a Turnaround Company
Do your research, buy a discounted business on the upswing, stay patient. Once in a while, a company will go through a horrible bankruptcy and end up restructuring (or getting bought out). Perhaps it can get out from under huge amounts of debt or it has a lot of inventory or capital equipment or real estate or patents or other valuable assets, even if they'll only end up sold off.
Maybe it just needs some extra love and attention to get the business back in order.
These investments are rare. It's not easy to predict when an airline will turn around or when a Canadian plutonium mine will find a new vein—but it happens.
If you're careful and do your value analysis, sometimes you can find diamonds in the rough: companies with a turnaround potential. Sometimes the market is irrational and undervalues a business. It's unfair, but it happens and it represents a real opportunity.
This is rare and risky. Most penny stocks are terrible opportunities, with flawed businesses and business models. The best penny stocks today won't be penny stocks for long.
Are Penny Stocks Worth Buying?
Even if a stock has a great price, and if it seems like 25 cents per share should be easy to double or triple your investment, be calm and careful. Do your research. You won't get rich by spending all of your available time looking for undervalued stocks priced under a dollar, but you can make good money with value investing even for a stock worth thousands per share.
Remember, the price of a stock represents the value of a company, especially the money the company can produce over time, the expected money that could be returned to shareholders if everything were sold off today, and the overall market sentiment of the business as a whole. If you limit your stock searches to something like "the best 1p shares to buy" or "stock prices under a dollar", you'll end up only looking at businesses with long shots to success. You could guess right and get lucky, but doing this repeatedly means you have to be very, very right in dramatic ways.
Stick with what you can buy and sell fairly. Leave the luck to scammers and gamblers.