What Does It Mean To Invest In Penny Stocks?
What exactly is a penny stock? According to the SEC, the official penny stock definition is any stock that is valued under $5. This means that they are cheap stocks which makes it easier for investors with small portfolios to have a stake in a company.
As a result of their low cost, small increases can actually result in massive gains. For example, if a $200 stock moves $1 that is only a 0.5% gain but if a $4 stock moves $1 that is a 25% gain. Catch my drift?
What Are Penny Stocks?
Before we get started, it’s good to actually know the answer to the question, “What are penny stocks?” For those of you who already know, keep reading. But if you’re new to this, stay here for a minute. The definition of a penny stock is one that trades below $5 a share. These are usually start-up stage companies, they’re early on in their business model, and likely have low to no liquidity. In comparison to larger companies, penny stocks carry with it more risk thanks to highly volatile trading activity.
In addition, you’ll likely hear about different definitions for penny stocks. The Securities & Exchange Commission defines penny stocks by the info above. However, most retail traders will explain that penny stocks are ones trading below $1 per share; aka “pennies on the dollar.” No matter your definition, the fact is that these stocks carry with them big potential for huge gains and losses within a short span of time.
Are Penny Stocks A Good Investment?
You may have heard of traders being very successful trading penny stocks. Generally, these successes come from unknown companies that were trading at less than a penny. This is a clear advantage that penny stocks have over larger stocks in the market.
As far as determining if penny stocks are a good investment, there’s a lot to consider. It’s true that you get to enter a company before most larger firms. If it’s successful you get to reap all of the benefits. This allows penny stocks to be both a short-term and long-term investments. However, you also need to consider the risks involved; mainly volatility involved with penny stocks.
Risks of Trading Penny Stocks
Penny stocks are extremely risky and can lead to inexperienced traders losing all of their money very quickly. This is something that everyone who is new to trading penny stocks must be aware of. In order to mitigate this risk, investors should trade with stop-loss orders.
A stop-loss order is an order type that triggers once a price falls to a certain level. For instance, if you have a stop-loss order at $1, then the moment a penny stock falls to $1, a sell order is triggered. This allows you to not have to hover over trades and will also prevent you from losing more money than anticipated.
Because of the speculative nature surrounding penny stocks, you should never make them the majority of your investment portfolio. It is essential to have a little bit of everything in that portfolio in order to maximize its diversification and limit risk.
Another way to deal with the risks of penny stocks is to trade with a game plan. If a trader comes in with a game plan, the likelihood of becoming successful at making money is likely to be greater. I reference finding success in making money because that is the reason we invest.
If you’re the best at buying and selling stocks but don’t understand when to take profit, you could end up with more losses than gains. Worse yet is spinning your wheels breaking even because you don’t have a strategy to truly take profit. This helps remove emotion from the trading equation making trades more focused.
Where Do You Buy Penny Stocks?
Penny stocks are generally found on the Over-The-Counter market as well as NASDAQ & NYSE in some special cases. Most trading platforms allow investors to trade over-the-counter stocks. One notable exception to this would be Robinhood’s platform. When you place a trade for an OTC stock you might have to pay additional fees depending on the trading platform you use.
However, there are other small-cap stocks that trade on major exchanges like NYSE and the NASDAQ exchange. In these cases, Robinhood does allow access to buy penny stocks like these. In either case, there are plenty of places to buy penny stocks. Check out some of these articles:
- Are These The Best 7 Penny Stock Trading Apps of 2019?
- How Do Free Penny Stock Trading Apps Make Money?
- Which Broker Is Best For Penny Stocks In 2019?
The Looming Stigma of Penny Stocks
In Hollywood and throughout history, bad actors have made the stigma around penny stocks very sour. We’re not just talking about bad acting in movies but actual “bad guys” who take advantage of penny stocks for the worst reasons.
From movies like The Wolf of Wall Street and Boiler Room to actual boiler rooms and pump and dump schemes, the concept of trading penny stocks is under fire. Sometimes all it takes is a little exposure to bring attention to these schemes to change the public perception.
Understanding that the nature around penny stocks is sketchy should reinforce the idea of doing your own due diligence. Never forget, you are investing your OWN money that you worked very hard for. That money should only go towards stocks that you feel comfortable and knowledgeable on.
What Taxes Do I Pay With Penny Stocks?
Generally, there are 2 different tax policies that revolve around trading penny stocks. The first is the long-term capital gains. This tax only impacts gains from stocks that were held for over a year. The second form of tax results from selling stocks quickly. If you sell a stock within a year, you are subject to the normal tax rate which is much higher than the long-term capital gains rate.
When it comes to long-term capital gains, they can be between 0% and 20% which is substantially lower than the typical tax rate, which is why investors like the stock market. This is important information to understand if you plan on investing in penny stocks. Most people involved in penny stocks tend to day trade or make intra-day trades. Holding penny stocks long-term is way riskier than holding for the short-term. But, if a stock turns “golden” in a year, you get to keep way more profits thanks to that long-term capital gains rate.
Final Thoughts
In conclusion, trading penny stocks is extremely lucrative. It can be very risky at times but with practice comes more experience and profits. We mentioned earlier how important it is to have a game plan when trading penny stocks so you can mitigate the heavy risks involved with them. Furthermore, if you are new to investing then you might want to stick to short-term trading even though you lose the tax benefit.
In any case, the basics of penny stock trading are more than just buying and selling. It’s important to understand that trading for gains is just as important as managing risk. Another thing to consider is “paper trading” where you can practice your strategy without risking real money.
