Evaluating the Risks and Rewards of Penny Stock Trading

Position-sizing, risk/reward analysis, and patience are critical elements of any sound trading methodology. Hasty decision-making is a big reason why many new traders take a big drawdown before they succeed.

Penny stocks are shares of stock issued by smaller, younger firms that have the potential to grow quickly. Such firms might be developing new technologies, for instance.

High Volatility

To be a successful penny stock trader, you will have to adopt high risk/reward ratio study. I would suggest that you dig deep in the research on every company you are buying stocks – financial stats, news feeds and SEC fillings.

Penny stocks also offer low liquidity; getting shot of your shares when you want could become difficult, and expensive. Substantial slippage can result.

Due to their low liquidity and lack of meaningful disclosures about micro-cap companies, they are ideal scam vehicles because you can easily manipulate the price. Traders who follow influencers can be lied to and tricked into buying shares pushed by fake or misleading posts on YouTube, Instagram or Twitter; fraudsters can hype and buy the stock, which drives up the price, then they can sell the artificially inflated stock at a profit later, in so-called ‘pump and dump’ schemes; investors who follow in buying the stock run the risk of losing significant amounts of money in these scams. So, traders should avoid any kind of promotion.

Low Liquidity

The low liquidity of penny stocks makes it difficult to trade at fair prices and sets traders up for wild price swings and losses. Tight spreads are essential for allowing the market to be transparent and helping avoid these pitfalls.

Trade-Markets.com, offering low-priced stocks but charging a commission, popped up is a ‘young company looking to grow quickly’, with all the attendant dangers of speculative investment: over-the-counter securities without detailed reporting that go along with shares traded on Nasdaq or NYSE, meaning they might be poorly regulated and thus more prone to extreme price movements or ‘pump-and-dump’ schemes that inflate a share price and then drop it to zero.

Investors must do their homework before they rush in to invest in penal stocks, as good financial statements thoroughly reviewed could help determine if the penal stocks are healthy enough for potential investment. Penal stock investors should also stay abreast of developments in the industry, as well as breaking news, as there may well be some news that will affect the company’s ability to continue being profitable – these issues are even more important when penal stock investing involves short selling, as in those cases investors borrow the shares in order to sell and buy back the shares later.

Lack of Information

Trading and investing in penny stocks also warrants extra vigilance for lack of market information. Because these stocks trade on the OTC markets, where the underlying companies are not subject to the same disclosure requirements as are companies whose stocks trade on the New York Stock Exchange or Nasdaq exchange, traders and investors need to be aware of such investment types. How is one to ascertain the worthy and true value of a penny stock investment when real financial data for it is scant or non-existent? Add to this the high prevalence of the lack of market information for most penny stocks, and you get an environment that fosters the work of fraud and nonsense by charlatans: pump-and-dump schemes that thrive on these gaps in market and company information, with newsletter writers, bloggers and penny stock movers promoting alleged ‘hot’ penny stocks, then unloading their shares at a price that is well above the market price, yielding exorbitant profits for them. In fact, penny stock traders need to be especially wary of stock promoters who spread false news about the company in order to artificially pump up its shares, to be eventually sold for lucrative gains later on as the company shares deflate or drop like a lead balloon after the fireside. When trading and investing in penny stocks, traders and investors must pay close attention to disclosures in newsletters, asking whether the publisher or writer gets paid by companies he/she writes about and then dumps those shares at prices way above market price to get a huge profit; or if the newsletter writer (or any other stock pusher) disseminates false news about a company, only to sell their now-higher-priced shares later.

Although it’s possible to make good returns this way, investing in penny stocks is risky, and not just because such stocks are more volatile than blue chip stocks or have problems with liquidity. Highly speculative, penny stocks bear the risk of dramatic declines in value.

Fraudulent Markets

These penny stocks are offered by tiny companies that don’t have to file detailed financial data with the Securities and Exchange Commission. They might represent dubious enterprises, giving fraudsters or reckless, untested companies a chance to sell purportedly worthless stocks to gullible investors, and promising them easy riches.

Their low liquidity and lack of investor information technology makes them especially susceptible to fraudsters engaged in so-called ‘pump and dump’ price-manipulation schemes. These operators hype penny stocks through spam emails and social media to get investors to drive up demand, then they sell off their holdings at unfavourable prices, leaving real investors holding near-worthless stock.

While penny stocks may seem tempting, these stocks are far more risky than those traded on exchanges. Make sure you are investing an amount that you’d be comfortable losing; conducting your own research and creating an exit strategy are the best ways to shun these black markets.

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