Have you ever heard of Tim Grittani? He’s a young trader who put his life savings into stocks back in 2010 and has since raked in millions of dollars.
Here’s the kicker: His original stake — his life savings — totaled only $1,500.
How did Tim turn such a small amount into a fortune?
He traded low-priced securities commonly known as “penny stocks.”
Can and — more importantly — should you do it too?
Before you plunge into the world of trading penny stocks, let’s take a look at what exactly these securities are and the risks they entail.
What Is a Penny Stock?
To put it simply, the U.S. Securities and Exchange Commission (SEC) defines “penny stocks” as stocks that trade below $5 per share. Many of them cost less than $1 (hence the name).
That sounds great for the budget-minded investor, right?
Well, those low-priced stocks come with some high levels of risk.
The companies behind penny stocks are tiny startups, rather than established businesses. For some lucky traders, such as Tim Grittani, these exciting stocks can yield quick and stratospheric gains when these startup companies make headlines or get bought up by bigger entities.
Unfortunately, many of these fledgling companies won’t survive for very long. And even if they do survive, their stock can plunge literally overnight.
That makes penny stocks highly speculative in nature.
Another big problem with these little stocks is that they trade “over the counter” (OTC). This means they’re not on the major public exchanges such as NYSE or the Nasdaq. The most common U.S. OTC exchanges are the Pink Sheets and the OTC Bulletin Board (OTCBB), which is operated by FINRA, a private self-regulatory organization.
Neither of these exchanges requires minimum standards for listing. And while the OTCBB requires some regulation, the Pink Sheets does not. Stocks on the Pink Sheets are not required to file with the SEC, so it’s pretty much the Wild West of stock trading.
Penny Stock Scams
Sadly, there’s another big problem with penny stocks. Because they’re not listed on the major exchanges, they have low liquidity. This means they’re harder to sell. On top of the threat that you may not be able to sell your shares when you want to, this makes them susceptible to scams in which unscrupulous traders manipulate their pricing.
You’ve probably heard of “pumping and dumping.” Unfortunately, this happens all of the time with penny stocks. A trader will “pump” or boost the stock price. This is often done by spreading misleading information or false “tips” about the company. Then, when more people pile into the penny stock, raising its price sky high, he’ll “dump” it, taking profits and sending the stock price way down.
Of course, pumping and dumping is illegal, but as I said before, the OTC exchanges can be a bit like the Wild West. It does happen, so if you do choose to trade penny stocks, always be aware of these scams. If it sounds too good to be true, it probably is.
Should I Trade Penny Stocks?
For some, the siren song of the penny stock is strong. After all, it’s possible to make a large amount of money in a short period of time without putting out a huge amount of capital.
Plus, there are some penny stock companies that will go on to become tomorrow’s successful companies. Believe it or not, Monster Beverage (MNST), the popular energy drink company, traded for years below 5 cents. Today, one share of MNST will run you more than $57.
However, these bite-size securities pack king-size risks. No one should put a penny into a penny stock unless they’re prepared to lose 50% to 100% of their investment. For every Monster Beverage, there are hundreds of penny stock companies that have failed.
Folks who are close to retirement, in particular, should avoid these stocks, since you could lose some of your portfolio. Higher-risk trades are better suited to younger investors, who can better stand to lose and recoup. (And remember that we here at Investor Junkie will never recommend day trading.)
If you do decide to try your hand at penny stock trading, we suggest that you paper trade for a while to get a hang of the strategies you’ll need. While there are many stock brokers that offer virtual trading accounts, you can also do it the old-fashioned way with a pen and a piece of paper.
Once you’ve “practiced” penny stock trading for a few weeks and are ready for the real thing, you’ll find that a number of the biggest online brokers will support penny stock trades. Many of the brokers we review here at Investor Junkie let you trade on the OTC markets, including our current recommended pick, TD Ameritrade.
If you can tolerate the risks of penny stocks, be sure to always do your due diligence before placing a stock. Is the “hot tip” you’ve heard verifiable? Or could it be a rumor spread by a pump-and-dump scam artist? Does the company have what it takes to survive? Or is it already rolling down the path to bankruptcy? Will there be enough demand for your stock that you will be able to sell it when the time’s right?
It’s also a good idea to shy away from “hot trends.” By the time the financial media reports on trends, the ground-floor opportunities are already gone. It’s better to stick with companies that you know and understand. Look for penny stocks from firms whose business is in a field you’re familiar with, either from your career or a passion. If you’re a die-hard paddleboarder, for example, chances are you’ll understand what a paddleboard company needs to succeed.
Penny stocks should never make up the bulk of your portfolio. Instead, you should treat them as you would treat a lottery ticket purchase — it would be great if you win, but if you lose, no harm done.