Seven Things Americans Should Know Before Investing in Penny Stocks

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Have you been experiencing some serious FOMO lately? You’re far from alone – over the past year, Americans have watched the stock market moon to all-time highs. So, with little else to do during lockdown, you finally looked into trading stocks.

But after a bit of research, it hit you – most of the folks that hit big paydays plowed tens or even hundreds of thousands of dollars into their initial position.

Unlike them, you don’t have a money tree growing in your backyard. But if you’re careful, you won’t need one. Unlike conventional equities, you can buy penny stocks in bulk for only a few hundred bucks.

But things aren’t as easy as they seem. In this post, we’ll run down seven things you should know about penny stocks. 

1) What are Penny Stocks?

According to the Securities & Exchange Commission (SEC), a penny stock is any equity that trades for less than $5 per share. Because of this, you can find penny stocks on any stock exchange – even the Dow Jones, NASDAQ, and the S&P 500 have them.

However, when most people talk about penny stocks, they’re referring to equities worth less than $1 per share. But you won’t find these stocks on conventional exchanges, as most delist companies that fall below $1.

2) Most Penny Stocks are Traded on the OTC Markets 

So, where can you find sub-dollar per share penny stocks? To buy them, you’ll need to trade on the OTC market. OTC stands for over-the-counter, which refers to how OTC stocks are traded.

Unlike the Dow Jones or NASDAQ, the OTC market is not a centralized exchange. Instead, it is a network of dealers. This is where the term “over-the-counter” comes from – instead of going through a central exchange, you’re buying shares from dealers directly over their counter.

This setup has its pros and cons. On the positive side, money-hungry enterprises can raise equity from the public far more quickly, and investors can buy up shares in promising startups.

However, unlike mainstream exchanges, OTC markets often suffer from capitalization issues. In the S&P 500, Dow Jones and NASDAQ, massive investment banks serve as market makers. That is, they provide the capital needed to facilitate trades.

In the OTC markets, the dealers are the market makers. These small operations don’t have the deep pockets that Goldman Sachs or Barclays does. So when volume is heavy, lacking sufficient cash can delay the processing of trades. That’s not a good situation for traders when a stock is plunging 10% or more.     

3) Penny Stocks Are Incredibly Volatile

That brings us to our next point – volatility. Because of the affordability of penny stocks, they are often subject to considerable hype. When a specific equity gets significant attention from investment blogs and newsletters, buying activity spikes, causing its price to increase exponentially.

These price rises usually precede a major announcement, like the outcome of a drug trial. When these announcements don’t result in a happy outcome, the price of an affected equity can tank HARD. As mentioned above, lack of timely access to capital can delay sell orders, leading to a bigger loss than expected – beware!

4) Learn the Fundamentals of Stock Trading Before Diving In

So, you’re ready to start trading – great! However, before spending a dime on penny stocks, take time to learn trading basics. Search for courses on platforms like Udemy – they will contain all the information you’ll need to get started.

By the end, you should know the difference between a call and a put, bear and bull markets, and more.

5) Always Do Your Research

Now it’s time to make your first trade – so, what should you buy? The answer changes with every equity you look at. It all starts by asking questions about its fundamentals. 

What sector are they in? How much revenue did they bring in last quarter? What are their expenditures like? Is their leadership team competent? These are just a few examples – you should have an exhaustive list of questions that addresses every unknown you can identify. 

There’s no way around it – getting satisfactory answers can take hours. It’s much more involved than simply buying whatever a newsletter tells you to buy. But if you put in the effort, you’ll have a much greater chance of turning a profit.    

6) Watch Out for Pump & Dump Scams

Some penny stocks don’t have anything special going on. However, that hasn’t stopped bad actors from targeting these equities at random. They buy a position, then they promote it aggressively to retail investors.

Your Average Joe doesn’t do research – they buy whatever is hot, hoping it’ll “go to the moon”. Pump-and-dump scammers prey on this lottery mentality – as their hype draws in early adopters, their sell job becomes easier. As the price of the targeted equity spikes, the fear of missing out (FOMO) does the rest.

Then, at a predetermined time, the original investment group dumps their shares at a massive profit. This act causes the price to collapse, leaving their victims holding the proverbial bag. In investment circles, this tactic is called a pump-and-dump.

If there is no apparent reason for the sudden appreciation of a penny stock, stay away.

7) Penny Stock Success Takes Time

By now, you should understand why penny stocks are so popular. The average person seeks a quick fix to their investment problems. So they approach the OTC markets with a lottery mentality, hoping that the next hot stock is the one that makes them rich. This approach almost always ends in tears.

And yet, some traders enjoy long-term success trading penny stocks – and they aren’t pump-and-dumpers. People like Timothy Sykes have made millions buying & selling these equities – but they’ve done it over decades, not months.

How do they do it? By investing in lifelong education, learning from their mistakes, and applying those lessons to subsequent trades. It’s not a silver-bullet solution, but it’s the truth.

Do Your Research and Invest With Care

Nothing worthwhile comes easily. If you want to grow wealthy through penny stock trading, commit to a continuous research and learning process. When you lose, don’t take it personally – find the lesson, learn it, and move on.

As you go along, you’ll build a process that works. That said, we wish you nothing but the best of luck.

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