Penny Stocks: Should You Dare?
Historically, penny stocks were stocks that traded for less than $1 per share, hence their name. However, the term is now used to describe securities trading for up to $5 or less. These are usually associated with small or new companies and are therefore highly speculative investment securities. Because their share prices are so low, even minor price changes measurable in cents or one or two dollars translates to massive swings in percentage value.
Unlike common stocks with higher share prices, penny stocks don’t trade on large public exchanges like the New York Stock Exchange or the Toronto Stock Exchange. Instead, penny stock trades take place through the electronic Over-The-Counter Bulletin Board (OTCBB) or through private pink sheets. These are not actual exchanges, but instead function as a quotation service that simply lets you know the value of these low-priced securities.
If the share price of a penny stock increases to a sustainable value over $5 and they meet other stringent requirements, the stock can be moved to be listed on a larger exchange. However, very few penny stocks make it to more formal trading floors because many of the businesses trading shares worth a few pennies do not survive as companies.
In This Article:
How to Invest in Penny Stocks
- Open an account with a discount broker. Because penny stocks have such low share prices and are more suited to frequent trading, you’ll want to keep your trading commissions as low as possible. For this reason, you want to open an account with a discount brokerage, such as Questrade. The lower your trading commissions, the more you keep as profit from your trades!
- Research and select penny stocks to invest in. One of the main downfalls of penny stocks is there is not a lot of public information available on the companies. For this reason, you must be extra vigilant as to where you get your information. Try to stick to reputable investment websites, instead of the deep pages of Reddit. Verify the penny stock listing against information about the company, including their website and office address.
- Purchase the number of shares you want to own. Once you’ve selected the penny stock you want to buy, look it up on your brokerage trading platform, or have them do it for you if it’s an automated robo-advisor, like Wealthsimple. When you deposit your money with Wealthsimple, they’ll invest it in a series of ETFs and common stocks based on your risk profile. They’ll manage all the buying and selling, reinvest your dividends, and even take care of tax loss harvesting. You will be able to view its historical performance and current price, as well as execute your trade. Select the number of shares you want and make your purchase and done.
- Craft your exit strategy. Now that you’re holding penny stocks in your portfolio, you’ll want to be ready to sell them when they hit your target price. Remember, liquidity is a huge issue for penny stocks, so you need to watch them closely. Know both your low and high price before you make your trades, so when the stock falls or rises to your exit point, you sell immediately.
- Reap your profits, cut your losses, and try again. Playing in penny stocks is an active investing strategy, so if you’re truly hoping to make any real money trading, you’re going to have to stay in the game! Leave your long-term investments on autopilot in a robo-advisor or selection of ETFs, so you have the time and capacity to manage your short-term trades.
Why Invest in a Penny Stock?
Penny stocks are very affordable based on their share prices, making them a very accessible investment compared to more traditional securities listed on larger exchanges. Likewise, their volatility can translate to massive gains if traders play their cards right.
If you already have a robust and safe investment portfolio that ensures a secure retirement, you might be looking for more fun and speculative plays in the stock market. Penny stocks should be considered alongside stock options as high-risk ways to get more profit out of the stock market, so if you’re looking for a low-risk investment solution, this probably isn’t for you. This is a great option for experienced traders who have cash to spare to gamble in the market, because they’ve already taken care of their long-term financial security in safer investments.
Risks vs Rewards of Investing in Penny Stocks
Like all investment decisions, there are risks and rewards to be weight when deciding whether or not to invest in penny stocks. Here’s a breakdown of the upsides and downsides of choosing penny stocks as investments.
Here are some of the risks of investing in penny stocks:
- Extreme volatility and tendency towards negative returns. Unfortunately, most of the companies trading as penny stocks will never make it on to larger exchanges, and often the reason is because the company will not survive. If the company goes under and their stock goes to zero, you lose your entire investment.
- High risk of fraud and scams. Because penny stocks are not regulated the same way as securities listed on larger exchanges, they’re susceptible to fraud and scams. If you’ve ever seen Wolf of Wall Street, you’re already familiar with the strategy of “pump & dump”: a broker sells penny stocks to retail investors which drives the price up, the broker then sells their position at a massive profit, and the stock crashes so the investor loses their money.
- Lack of Liquidity. Penny stocks don’t trade as frequently as the shares of larger companies, which means they will be harder for you to sell when you want to. Whether you’re trying to capture investment gains or simply want to ditch a losing investment, getting someone else to buy your penny stock from you isn’t always easy. The lack of liquidity with penny stocks means you’ll rarely get the price you want when you sell your shares.
- You still need to invest a significant sum if you want a large payout. Finally, while penny stocks can seem a tempting way to make a lot of money, you still need to invest a lot of money to reap high returns. Even if a $0.80 penny stock doubles in value to $1.60, if you only owned 100 shares, meaning you paid $80, you’ve made a whopping $80. To earn thousands of dollars trading penny stocks, you’ll need to invest thousands of dollars in penny stocks – which you should only do if you can truly afford to lose thousands of dollars!
Here are the main rewards of investing in penny stocks:
- High potential for quick gains. The main reason people are so attracted to penny stocks is the opportunity to make a huge return in a very short amount of time. Where most common stocks will move, at most, a few percentage points in a single day, penny stocks can double in value in a matter of hours.
- Easy to access. Buying penny stocks is as simple as looking them up in your brokerage account and making a trade. If you already hold common stocks and ETFs, adding penny stocks to your portfolio is as simple as logging into your brokerage account and buying them through your trading platform.
Dos and Don’ts of Penny Stocks
- Buy your penny stocks through a discount broker. While you can trade penny stocks over the phone, you’re better off using a legitimate brokerage to ensure you’re really getting what you pay for. When you buy your penny stocks on a brokerage platform like Questrade, you can rest assured you own them and they are real. But if someone calls you or you catch an advertisement for a “hot penny stock”, more often than not, the company is not legitimate and you’re simply donating your investment money to a scammer. Always use a broker you know and trust to protect yourself and your money.
- Invest money you can afford to lose. Penny stocks are high-risk, almost never pay dividends, and your investment is more likely to go to zero than with more traditional securities. For this reason, the money you invest in penny stocks should only be money you can afford to do without, should you lose your entire investment.
- Capture your gains when they happen. It can be tempting to hang on to a runaway winner if one of the penny stocks you’ve chosen is doing well. However, it’s important to remember penny stocks are significantly less liquid than traditional common stocks, which means they’re not as easy to trade. For this reason, if you have paper profits in your penny stock portfolio, make sure to capture them by selling all or part of your position when the opportunity arises.
- Take your losses in stride. Nobody wins every trade they make, and this turns out to be especially true in volatile securities like penny stocks. If you’re trading penny stocks, sometimes your investment will go to zero and you will lose the cash you invested. Being a successful trader doesn’t mean never losing money, it simply means winning more often than you lose. When investment losses happen (and they will happen) try not to beat yourself up. Save your mental and emotional energy for trades that are doing well!
- Don’t get carried away. The accessibility and affordability of penny stocks can make it easy to go on a spending spree chasing hot stock tips, but you should still stick to a trading plan and only buy shares in what you know and understand.
- Don’t buy penny stocks in registered accounts. Because penny stocks are high risk and volatile, it’s best to keep them out of registered investments accounts like the TFSA or RRSP. If a trade goes badly in either and you lose the money, you never get that contribution room back. Furthermore, the CRA is watching trading activity in Tax-Free Savings Accounts to ensure it does not constitute as business. Frequent, high-profit trading that is characteristic of penny stocks can incur an income tax bill in the TFSA, defeating the purpose of the account! For these reasons, make all your penny stock trades in an unregistered brokerage account.
- Don’t borrow money to invest in penny stocks. This might seem like a no-brainer, but a lot of people tend to wonder if it’s a good option. Bottom line: don’t take on debt to invest in penny stocks The extreme volatility and tendency for shares to go to $0, means borrowing money to invest in penny stocks can leave you with a debt balance and nothing else.
Where Can I Find and Trade Penny Stocks?
It’s never been easier to buy and sell penny stocks. Large online brokerages will let you access OTC and pink sheet securities, which means you can buy and sell penny stocks right along more traditional securities listed on large exchanges.
However, because penny stocks are not listed on the NYSE or TSE, you may find some brokerages, especially small discount brokers, don’t have them. Most of the brokerage accounts with the big banks will allow you to buy and sell penny stocks, as will Questrade. However, smaller platforms like Wealthsimple Trade will likely have limits on what penny stocks you can access because they don’t support securities listed off the large exchanges.
Should I Invest in Penny Stocks Right Now?
Now is not a bad time to invest in penny stocks, but the impact of the global COVID-19 pandemic is making the stock market more volatile than ever. Unfortunately, this means penny stocks will also be more volatile than ever.
Because the companies usually listing their stock at less than $5 per share are new start-ups trying to raise capital, they are particularly vulnerable to economic shocks. Since COVID-19 is hitting small businesses particularly hard because they don’t have the resources to weather economic downturns, you should assume penny stocks are extremely risky right now.
This doesn’t mean there aren’t good investments to be had, and it doesn’t mean that you can’t make money trading penny stocks. However, it does mean the risk is heightened and you should be extra cautious about the investments you select for your portfolio.
If You’re Not Ready for Penny Stocks…
If it’s clear from the above that you’re not ready for the high-risk trading of penny stocks, there are plenty of safer ways to build wealth in the stock market! Instead of investing in penny stocks, focus on buying Exchange Traded Funds (ETFs) or common stocks instead. These securities have higher share prices but are less volatile and less risky than penny stocks.