Post Type

The Risks of Penny Stock Trading and Why You Should Never Do It

Investing in penny stocks are something a lot of new investors tend to get into. To be honest, I tried trading them myself. Most people say “Hey, you know what; I can make some quick money off of this. I just need the price to go up by like $0.10 and I can get out and make $200”. It’s super sexy to imagine yourself trading penny stocks and making a fortune.

That sounds great in theory, which is why new investors naturally gravitate towards penny stocks. But, investing in penny stocks isn’t all it’s cracked up to be. Some people do make money on it, but the vast majority end up losing money.

So, let’s do a quick walk through and evaluate investing in penny stocks. Hopefully, by the end of this I will have helped you avoid one of the biggest mistakes most new investors make.

Penny Stocks Are Speculation

The main reason you want to stay away from penny stocks is because they are based purely on speculation. There are no underlying fundamentals that are driving the value of these stocks. It’s purely people making a very risky investment. In some cases, the fluctuations are driven by pump and dump schemes and that’s where average investors get caught and lose money.

The prospect of making a lot of money from a small price movement makes it seem like an attractive investment, but 99% of new investors that try penny stocks will most likely end up losing money.

Why People Are Drawn to Penny Stocks

In most cases, its new investors that gravitate towards penny stocks. I did it myself when I first started investing.  Making money is the ultimate goal of investing, and the people that are investing in stocks are the people that want to make money and set themselves up for financial success. So obviously penny stocks seem very attractive.

So, since penny stocks are not based on fundamentals, what makes penny stocks so appealing? Well penny stocks are appealing because people like the extreme volatility. A stock that can make significant moves quickly seems, at face value, like a great opportunity. At the end of the day, trading penny stocks and making money sounds enjoyable, exciting and sexy.

Only one problem… The volatility associated with penny stocks is what makes them inherently risky. It’s essentially gambling with your money. You’re not making a value judgment or analysis based on the revenue or operations of the company. Rather, it’s kind of like trying to ride the wave up, getting off (hopefully at the right time) and then letting the wave come crashing down. If you can time it, great! But, most people can’t and end up losing money. Especially those that are new to investing.

Patience vs. Impatience

When you think about it, investing in penny stocks boils down to a conversation about patience vs. impatience. Patience is a hard skill to learn, but it is essential to investing. When first investing, this is a skill set that most people are not inherently aware of and struggle with. Instead, they want to make money and want to make it quickly. This lends itself to a situation where you make emotional decisions and lose money.

Without patience, you’re not going to be able to wait out a company until they are able to implement things that will make them profitable. The greatest gains in stocks come over years, not days. However, with penny stocks, you’re inherently in a mindset that requires making a lot of quick trades in order to make quick money.

Fight the impulse of impatience. Our inherent love for volatility is something that every investor needs to learn how to control. Investing the right way is centered around long term gains and being patient with your investments. It sounds boring, but it’s much more likely to result in you making money rather than losing it.

Need to Always Watch The Markets

Another problem with penny stocks is the fact that there is a much smaller window to exit a trade profitably.  Penny stocks display greater volatility, which means a few hours can determine whether or not you lose money.

Price movements happen so quickly that might have a 2 hour gap where you can get out of a stock profitably. And if you’re not able to sell your shares, then you’re stuck taking a loss. This makes penny stocks impossible to invest in unless you are constantly watching the markets.

Big Gains with Small Portfolios

Another reason most new investors are drawn to penny stocks is because they have smaller portfolios.  If you are one of those new investors, you have probably considered investing in a penny stock at some point. Tripling your money quickly (to grow your portfolio) and then taking a less risky approach later seems like a good strategy. Again, it sounds good in theory, but implementation is different.

If you don’t have much money and you start playing with penny stocks, the chance of losing money and setting yourself a few months back is extremely high.

One problem with ‘trading’ when you have a small portfolio is transaction costs.  When you trade, your transaction costs are actually going to eat up a lot of your profit.

For example, let’s say you’re trading with penny stocks with a small portfolio using Options House. Options House charges $4.95 per trade. So, you need to make $9.90 before you are even able to sell the stock for a profit.

If you’re entire trade is only $50, you need to essentially make 10% profit before you can sell. That’s just not feasible or sustainable over the long run. You won’t be able to do it often enough for you to make a substantial amount of money.

Final Thoughts

Well, that’s about it for my rant on penny stocks. When I first started investing I tried trading penny stocks and it cost me a pretty penny. If I can even convince one of you to not try trading penny stocks, I’ll consider this article a success.

Try to stay away from penny stocks at all cost. View investing as a platform to grow your portfolio and net worth in the future. Don’t risk your money or gamble it away with penny stocks. I know it’s very appealing, but you will most likely end up losing money like I did and regret ever making those trades.

There are a small percentage of people that have achieved profitability with penny stocks. Those guys may have figured it out, but they probably lost a lot of money on the way while learning how to do it properly. So, unless you have the time and funds to dedicate towards it, try to stay away from it. Instead, use value investing and fundamental analysis to take a longer term approach and expose your portfolio to less risk.

Thanks, Sam

Have you guys ever tried investing in penny stocks? Any luck?