Last Updated on April 19, 2022 by Quantified Trading
Penny stocks offer a low entry and often the lure of striking it big. The internet is full of stories about how you can make millions and gain thousands of percent of returns in penny stocks. Is it any reality in this? Can you get rich trading penny stocks? Unfortunately not:
You are unlikely to get rich trading penny stocks. On the contrary, you are much more likely to lose your money. Penny stocks and OTC stocks have an average negative annual return of 24%. Over 90% of penny stocks fail.
Penny stocks – those that trade for low prices, often less than a dollar per share – are dangerous. Period. This is why:
What are OTC and penny stocks?
Practically all penny stocks are OTC stocks (over the counter). Let’s start by defining penny stocks and the OTC market since they both go hand in hand:
Penny stocks trade for low prices, typically below 5 dollars per share, and they are traded on the over-the-counter, or OTC, markets. OTC stocks are shares of companies that do not trade on major exchanges (like NYSE, Nasdaq, Eurex, etc.).
Because most OTC stocks are illiquid, have a small market capitalization, and few “professional” players they are often prone to huge moves. A one-dollar move in a two-dollar stock is 50%, while only 2% in a 50-dollar stock. This explains why investors are drawn to the OTC market. Traders and investors want to get rich quickly. This rarely ends well.
We have previously written an article explaining why penny stocks are bad.
Can you get rich trading penny stocks?
About three years ago, Tim Grittani decided to begin trading stocks with his life savings of $1,500. Today, the 24-year-old’s portfolio is worth more than $1 million.
The quote above is taken from an article on CNN Business. No wonder many are tempted to try to make money in penny stocks when they read headlines like this.
But the return properties of OTC stocks are very distinct from all other stocks listed on national securities exchanges and you are unlikely to repeat Tim Grittani. Grittani is the exception.
Typically, OTC stocks have returns that are negative, volatile, and highly skewed on both tails, but mostly negatively skewed.
That they are skewed is illustrated by the fact that the median return is lower than the average return. This means a few highfliers go on to make spectacular returns, while the great majority of the OTC are left in the bin. Even though a few go on to rise 1000s of percent, the great majority end up worthless.
How bad are the penny stocks returns? The returns in penny stocks are spectacularly bad:
Brüggeman, Kaul, Leuz, and Werner went through 10 000 OTC stocks from 2001 until 2010 in a study called The Twilight Zone: OTC Regulatory Regimes and Market Quality.
The results speak for themselves:
The average annual return for OTC stocks was -27% while the median return was -37%!
As you can see, investing in the OTC market is a bad idea.
Is Brüggeman et al’s test a one off wonder? No, it’s backed by other research:
Eraker and Ready published a study in 2015 called Do investors overpay for stocks with lottery-like payoffs? An examination of the returns of OTC stocks. On aggregate the OTC stocks return a negative 24% annually from 2000 until 2008. The OTC investors lost an aggregate of 180 billion USD over the sample period.
Penny stock investors lose on average 18 billion a year
According to a white paper published by the SEC called Outcomes of Investing in OTC Stocks, the typical investor loses a few hundred bucks per year playing the OTC market, but a few lose much more. In aggregate, investors lose roughly 18 billion per year in the OTC and penny stock market, according to the SEC.
However, a few investors and traders make significant amounts of money in penny stocks.
The same report from the SEC hypothesizes that many of the big winners from penny stocks are likely to be pump-and-dump scammers and promoters.
This is the distribution of the OTC investors in SEC’s study:
What if you trade penny stocks – not invest in them?
Holding penny stocks for short periods of time won’t protect you.
Many traders believe they can hold penny stocks for a few days and get out before they drop in value. But the SEC report states that the median investor holds their penny stocks for 16 days and realizes a negative return of 13.4%.
This means you are unlikely to ride a short-term squeeze. You are facing a huge headwind from the negative drag and only a few stocks occasionally rise in value. Furthermore, timing is very hard.
If so many penny stocks fail, is it a good idea to short them?
No, it’s a bad idea to short penny stocks. Let us explain:
Even though the median and average penny stock has a negative annual return you are unlikely to make money on the short side.
First of all, penny stocks are difficult to locate, meaning you are unlikely to find shares to sell short.
Secondly, if you manage to locate shares for selling short, both costs and the skewed return distribution would most likely lead to losses. A stock can rise unlimited, while it can only fall 100%. Because the penny stock market has a few stocks that go on to gain thousands of percent, you risk huge losses.
Please read our older article about why short selling is difficult.
Can you get rich trading penny stocks – ending remarks
We hope you have got an understanding of why you are unlikely to get rich trading penny stocks.
If you have small amounts of money you can risk and lose, by all means, go ahead and try to make it rich by trading penny stocks. But if you care about your money we recommend deciding on trading or investing. If you opt for trading, then go ahead and learn how how to be systematic. We believe backtesting works and is the best way to approach trading.