Are Penny Stocks Good For Beginner Traders?

For many beginner investors, the first logical step into the world of trading is usually penny stocks. The low barriers to entry and the dream of turning a few hundred dollars into substantial sums are two of the main reasons for their soaring popularity over the past few years (that, and the Wolf of Wall Street, let's be honest). Be that as it may, are they really the best place for beginners to start out, or would you be better off avoiding them altogether? Let's find out.

What are penny stocks?

First things first, let's start off with a clear definition of what a penny stock actually is, as there are still plenty of people who get it confused. The Securities and Exchange Commission (SEC) classifies a penny stock as any stock that trades at less than $5 per share. Yep, even despite the name "penny", a stock that trades at $4.95 is still technically a penny stock.

While these stocks are cheap, they often have a thin financial history, and it can be hard to dig up information on them. As such, they are a much riskier investment than a typically blue-chip company listed on the New York Stock Exchange. In some cases, the underlying company may be on the verge of bankruptcy - not exactly the best place to put your money!

Where are penny stocks listed?

As it turns out, there are some penny stocks to be found on large exchanges, such as the NYSE or the NASDAQ. However, the vast majority of them traded in the over-the-counter market via the OTC Markets Group. As a result, many traders like to break them down into four tiers. These are:

• Tier 1 - The upper echelon of penny stocks. These are traded on the NYSE and are far less risky than the stocks in the other tiers. This is because the risk of price manipulation diminishes due to the companies having to provide comprehensive financial information.
  

• Tier 2 - OTC stocks typically priced between one cent and 99 cents
  

• Tier 3 - OTC stocks traded below one penny per share
  

• Tier 4 - OTC stocks priced between 0.0001 and 0.0009 cents per share
  

As you might expect, the risk involved with these stocks increases dramatically the further down the list you go.

Are penny stocks suitable for beginners?

If you want to start trading penny stocks, you should strongly consider seeking the advice of a professional or at least enrolling in a reputable course. While trading these assets can be highly profitable, they often present a myriad of challenges that would likely cause a beginner to lose their trading capital and incur losses.

Having said that, let's take a look at some of the key considerations to be aware of when trading penny stocks for the first time:

Low prices

Penny stocks are cheap! You can buy thousands of shares for a relatively small sum of money. This means that even the smallest of price movement can result in huge gains (or losses). It also makes them extremely volatile, so keep your wits about you.

Lack of liquidity

A lack of liquidity is one of the biggest challenges when trading penny stocks. It's not all that uncommon to be stuck in an open position for days or weeks at a time. This leaves you exposed to the market's volatility and with no real way of accessing your funds. This happens because there simply isn't enough money flowing in and out of the stock. In other words, nobody is buying or selling in large quantities.

Additionally, a lack of liquidity makes it easier for more prominent players in the market to manipulate the price and make it look as if a stock is stronger (or weaker) than it actually is.

Large-spreads

Many small-cap stocks have wide spreads that make it very hard to profit as a trader. Again, this is a result of low liquidity. Amazingly, some of the spreads of penny stocks can get as high as 30 - 50%.

Fraud

As we have already alluded to in this article, there are people out there who actively attempt to manipulate the price of a stock. The most common "scam" involves artificially pumping a stock in order to raise the interest of other investors. These investors jump on the hot stock and pump the price even higher, creating massive liquidity. The scammers then dump their stock on unsuspecting traders for a huge profit.

This leaves the ones who bought at the top holding worthless stock and no real way of recouping their losses.

Final word

While there is always the chance to strike it rich with penny stocks, the best way to capitalize on them is by slowly but surely growing your trading capital with intelligent, sensible, and conservative trades.

However, proceed with caution! Whenever you trade penny stocks, you must be prepared for a "total loss" scenario, meaning that your open position becomes worthless or too illiquid to exit. Consequently, only trade what you can afford to lose and try to trade conservatively when dealing with penny stocks.

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