Are Penny Stocks Risky?

Ah penny stocks, the quick way to riches. This sounds like the Saturday morning infomercial with coffee and eggs; invest in penny stocks and make millions! Sign up for trading for free today! Now, is this all true? Not by a long shot, and I’m not saying to never invest in a small cap company. If you are an experienced investor and you see value go for it, but again There are no get rich quick options. That is the point.

Some definitions 
So what is a penny stock? Technically, a penny stock is one that trades at a share price of below $10 per share (standard definition). However, in recent times penny stocks have simply been know as small “pump-and dump” stocks that are supposed to be high growth (if they succeed) and are also very volatile in terms of stock price.

Why do penny stocks entice people?
The description doesn’t sound all that interesting does it? So why then, do folks go and try to make it big on penny stock “investing”? In my opinion, most of it is due to the market of manipulating young and small investors out there. Think about it, every time you make a trade on your brokerage account someone is getting paid. So people market and sell the idea that we all can make a ton of money quickly by investing in penny stocks, when the reality is that only a few highly skilled traders make a large portion of the money.

The issue with penny stocks
The main issue I see with penny stocks is liquidity. Let’s say that you invest in penny stock A and it increases 2000% and you want to sell it for a profit! That’s easy if your investment is in Facebook’s stock which trades millions of times per day, but with a penny stock there may be no active buyers willing to buy your stock, so you can’t actually take out that profit.

The second main problem with penny stocks is that…most of them fail miserably and their stock goes straight to zero. I experienced this myself with a penny stock in the consumer good industry. I invested 5k and lost every penny when the stock went to zero. Luckily, I learned my lesson early (when I first started investing) and have now made that money back several times over. However, the point remains that most of these small companies fail.

Shorting penny stocks 
I think there’s a few con artists out there that have claimed to have made millions shorting penny stocks, and some of their points may have some truth to them. It makes sense to short a penny stock because of how poorly most of them do. In this case one can borrow money from a broker and sell stock back to them in a short sell transaction. Then, once the stock depreciates in a value one can buy the stock back from the broker at a lower price, making a profit. This can work, but still entails significant risk, the main one being the potential for a margin call. If the stock goes too far against you, the broker will demand you pay them to make up your losses.

No wonder they say trading is the same as hitting up Vegas! So the lesson here is that it definetly makes sense to invest in the stock market, but avoiding penny stocks unless you are a very experienced investor is a good choice.