Risks of Penny Stock Trading

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Thinking of trading penny stocks? You can lose a lot of money. Here's why that's risky!

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 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 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 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 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. 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 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, which Lowe's 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. There aren't many buyers and sellers because they're so risky. Unlike a share of Coca-Cola stock 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.

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, 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.

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