Why You Shouldn’t Trade Penny Stocks (Why Avoid Them)

Last Updated on November 25, 2020 by Oddmund Groette

Penny stocks attract a lot of attention, both among investors and traders, but also among scammers, unfortunately. The traps are many, and we recommend to stay away from penny stocks. These stocks are not a way to get rich. They are more likely to send you to the poorhouse.

You shouldn’t trade penny stocks because many of the companies have unproven business models, they are illiquid, they are exposed to scammers, and they are very volatile. Most penny stocks end up worthless. 

What are penny stocks?

Despite their name, penny stocks not always trade in pennies, sometimes in dollars: The American SEC uses a much wider definition: any stock below 5 USD is a penny stock. There is no exact definition, but the majority of them doesn’t trade on any formal stock exchange like NYSE or Nasdaq:

Where are penny stocks traded?

Penny stocks are traded on all US exchanges, but the great majority of them are on the over-the-counter (OTC) and the private Pink Sheets. The Pink Sheets is a private company and offers a listing service for stocks that trade over-the-counter. OTC stocks are simply stocks that are not listed on a formal exchange like NYSE or Nasdaq. The OTC market is being served by a network of broker-dealers to make a market. The whole purpose of the OTC-market is to serve as a marketplace for small companies to bring together business ideas and investors for those companies which can’t make it to the exchanges or don’t want to.

Why do companies trade on the OTC markets and not on any exchange?

Both the New York Stock Exchange and Nasdaq are stock exchanges, and have strict requirements to get listed. Very few companies can comply with the exchanges’ requirements as it’s expensive. A rare few companies elect to stay on the OTC rather than the exchanges, but they are the exception.

Why trade penny stocks?

Most people are drawn to penny stocks because they dream of striking it rich.

This is of course unlikely to happen. Traders and investors with small accounts dream of making a killing in these stocks, but are much more likely to end up as prey for bigger and more informed players higher in the food chain. These are often scammers.

The typical arguments for trading penny stocks are these:

  • You don’t need a big account to trade them. A stock at 10 000 shares at 10 cents is worth only 1 000 USD.
  • They are very volatile – you can hit a home run – a multi-bagger. An increase from 10 cents to 20 cents is 100%, while only 10 cents in gain.
  • The OTC-market is like a lottery ticket. We know from behavioral studies that investors are attracted to binary outcomes.
  • Scammers are attracted (because they know investors enjoy lotteries).
  • Most companies once started small.

Any stock that has the potential of becoming a multi-bagger looks attractive, no matter how low the odds are. But all your efforts have an opportunity cost: is your resources better spent elsewhere? How likely is it that you will be successful in trading low priced stocks? Do you have the competence to deal in unregulated markets?

John Deere (DE) is likely to become a multi-bagger, but you need to own it for decades. This is not attractive to penny stock traders. The ability to delay gratification is a rare thing to have, and stories about traders making a killing in penny stocks are simply too hard to resist. Thus, you go looking for the next diamond on the Pink Sheets instead of John Deere.

One famous trader in penny stocks wrote this on his website:

Oh – and just to put this into context, although the S&P 500 topped 30% returns in 2013, its annualized return between 1926 and 2013 is only about 10%. Since more than nine out of ten professional money managers fail to beat the S&P 500, it’s going to take even longer to turn a tiny account into a million dollar holding through traditional stock market investing….. I don’t know about you, but I don’t want to wait that long!

Yes, why invest for “only” 10% when you can get 30% and more trading penny stocks? This is the lure of the OTC markets. Don’t fool yourself! Richard Feynman wrote that the first principle is that you must not fool yourself – and you are the easiest person to fool.

The quote above is typical for many websites, but surely something you will never hear us tout at Quantified Strategies. In order to get more than the market’s 10% annual return, you either need to take a lot of risks, find a temporary inefficiency or simply be very good at developing quantitative strategies.

It’s of course possible to make a lot of money trading. We have been reasonably successful ourselves, but don’t fool yourself to think that penny stocks are the holy grail. It’s not.

Has anyone ever got rich trading penny stocks?

Of course, but you never hear about the ones losing their shirt (and homes). The argument is often that any large-cap once started small. But you can’t look at the success stories without looking at the stocks gone into oblivion. It’s easy to overestimate yourself using hindsight.

Warning: Are penny stocks worth the risk?

If you ever start trading in penny stocks, please put this on your wall:

Penny stocks are high-risk and among the most speculative investments there is. I might lose 100% of my investment. Almost 100% of penny stocks ultimately fail and end up on the graveyard. Ignore all the success stories and be realistic.

Some people are comfortable with this risk profile, while others allocate a small percentage of their assets to this kind of trading. That is OK.

What is not OK is to start without understanding the potential risks and pitfalls. Make sure you do proper due diligence if you decide to go for the jugular in penny stocks.

The rest of the article contains arguments against penny stocks and why you need to be very careful:

Penny stocks are mostly unproven business models

Why do most penny stocks fail?

Because nearly all of them have new and unproven business models. It’s a natural filter in the markets: those who are strong, creative and adaptable survive. The rest fail. The OTC markets produce binary outcomes: either good or bad, seldom something in between. You are more likely to find companies that enter bankruptcy among penny stocks than higher-priced stocks.

Some other categories of stocks are frequent among penny stocks: companies that have fallen from glory and is on their way into oblivion, companies with just one service or product, or even companies with no history of profits at all.

This is in stark contrast to large-caps that generate huge profits and have a long track record.

Penny stocks operate in “unregulated” markets

Less regulation means less financial disclosure. Stocks on the Pink Sheets are not required to file financial reports to the SEC. There are no minimum standards on the Pink Sheets except a minimum price of 0.01 USD and it can’t currently be under bankruptcy proceedings.

Low liquidity

Most stocks on the OTC are illiquid and thus very difficult to both buy and sell. We are not talking about commissions, but the cost in the form of the difference between the bid and the offer. In trading slang, this is called slippage. Perhaps needless to say, the spread increases when volatility picks up. Dealing in low priced stocks is very expensive due to this.

Most penny stocks are not eligible for free commissions like on the exchanges. If you pay a commission per share traded, this is likely to be very inefficient on penny stocks. If you pay per trade you are likely to fare better.

Lack of info and research

Less regulation means no requirements for providing financial info. If you want to invest, you need to find the information yourself. Very few brokers cover OTC stocks. This could be both good and bad. The good thing is the opportunity to find an overlooked gem, while on the flip side you trade on little knowledge of the stock.

Competition in the OTC market is less than in for example Microsoft. Millions of people research Microsoft every year, and you must be pretty good if you gain an edge via information or analysis.

Opposite, among the OTC stocks you can actually manage to find some information that is not discounted in the share price.

Penny stocks are mostly bad companies

Let’s face it: Sometimes even famous companies and brands end up as penny stocks, as happened to many during the GFC in 20008/09. Usually, they have dropped substantially in price and are struggling to make a profit, perhaps more likely running at a loss. Thus, they can actually in reality be worthless.

Penny stocks are often liable to scams

Penny stocks themselves are usually not scams but a legal and honest business, but the thinly traded market make them exposed to scammers. What kind of scams should you be aware of?

The Robust Trader mentions three typical scams:

The ‘know-it-all’ scam

Many webpages claim to have the winning formula. As a new investor, it’s easy to fall for scams like that. More experienced traders and investors are not so easy to fool. Any “gurus” that claim to have a secret formula should be avoided at all costs. There are no shortcuts in the stock market. And never pay any money upfront!

No course can teach you a winning formula. Trading is a trade like no other, and any online trading course should be about how to develop yourself and your skills: No “guru” can ever provide you a winning formula. Don’t be the one going from one online course to the next in search of the magic trading strategy. It doesn’t exist.

A good way to start is to look at our free trading edges and strategies.

The pump and dump scam

Did you see the film Wolf Of Wall Street starring Leonardo DiCaprio? This is what most pump and dump schemes are about: the greater fool theory.

Some clever marketers find a way to push the stock price up in illiquid penny stocks. Whatever promotion they do, a rise attracts other traders and the scammers sell their shares into the hype.

Any successful penny stock trader is most likely the result of a successful pump and dump scheme. Some might have done it via ethical methods, but they are the minority. Penny stocks are very much a zero-sum game.

The dump and dilute scam

This is a scam by the company itself and thus is not likely to happen (most businesses in the OTC markets are honest and legit). This can for example be done by issuing shares by raising money from investors. The proceeds are not spent on the business, but elsewhere.

Sometimes a company makes an inverse stock split: ten shares suddenly is only one. Because of the less transparent market and lack of requirements, many investors might be deceived to believe something fundamental has happened.

Conclusion:

We suggest you are very careful with penny stocks, to the extent that they should be avoided. They are mostly unproven businesses or failing businesses. Almost all fail. Ignore the very few success stories – they are most likely due to scams.

Before you dip your toe in the unregulated markets ask yourself the following:

Where are you in the food chain? Are you the predator or the prey?

 

Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.