A penny stock can be a funny thing. Though many people suspect manipulated share prices or questionable businesses, people will continue to invest in them. Research from the National Bureau of Economic Research has found this unwavering attraction to penny stocks in a study. But what is actually the true attraction to buying a penny stock?
The Truth About Penny Stocks
In short, investors are attracted to the profit multiples. Mathematically speaking, it would seem much easier to double your money if a $1 stock moves to $2 than it would for a $100 stock to move to $200. Since the technical definition of a penny stock is a stock that does not cost more than $5, there is a very large pool of penny stocks to buy. Though it may seem easier for $1 to turn into $2 or $2 to turn into $10, that may not always be the case.
The odds are actually higher that you could lose more money than gain from a penny stock. Just as quickly as penny stocks can increase in percentage, so to can they decrease. Make sure to keep some things in mind:
- Penny stocks are usually listed on the Over The Counter Bulletin Board or OTC Link. This means that financial reporting requirements are not as strict compared to NYSE or NASDAQ listings.
- Penny stocks usually have underlying companies that are in their earlier stages, pre-revenue, and even pre-business model. Little to no track record, lower cash
and higher debt are the norm. - Penny stocks are highly speculative and not as liquid as their NYSE or NASDAQ listed peers.
- There are even strict rules on penny stock trading that are brought down from the Securities and Exchange Commission to “protect” investors.
Checklist For Penny Stocks Before You Buy
But knowing is half the battle in penny stocks. If you’ve made it this far, you most likely want to know if an investor can actually uncover a “hidden penny stock gem.” In short, it’s possible and important to know some guidelines:
- Focus on penny stocks with earnings or near term earnings potential.
- Don’t trade solely based on a penny stock newsletter. Most times these newsletters are paid to promote certain penny stocks and some will even own shares of the companies that they promote, which could negatively impact the market.
- Look for penny stocks that trade with heavier volume (higher liquidity). There is a greater likelihood that you’ll be able to enter and exit a trade if there is a liquid market. It will be easier to buy the penny stock than it will be to sell that penny stock. This is because many penny stocks are illiquid
- Be cautious of stocks that have a lot of
buzz . The name of the game is to make money and in penny stocks, many social media influencers will hype a penny stock in order to create fear of missing out (FOMO). In doing so, they end up getting people to buy into the hype. This happens all while they sell their shares. After the hype is over, there is little or no support to hold up inflated prices. Being aware of this can help you avoid over-hyped penny stocks and focus on ones that have strong fundamentals for a lasting bull run. - Patience can pay off. When you talk about penny stocks, it’s important to be patient; don’t get FOMO. If you have a penny stock investment idea, it may be prudent to sit back for a moment and what the stock trade. Take into account all of the previously mentioned guidelines. Be able to make a well-established thesis in order to place your penny stock buy order.
There is no silver bullet to making money with penny stocks. But having a plan before you go into any trade can help you make more money and avoid potential losses.
