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For a long time when someone would say “penny stock”, it conjured up images of a business that had fallen on hard times or some kind of possible investment scam. However, in early 2020, a group of amateur investors on Reddit made major waves when they rallied to buy the penny stocks of two well-known companies: GameStop and AMC.
Lots of people made tens or even hundreds of thousands of dollars in a relatively short amount of time, and it brought a lot of media attention to this strategy.
With trading apps like Robinhood offering commission-free trades, many investors feel like they’ve got nothing to lose on penny stocks. But does that necessarily mean that they’re still a good investment? After all, didn’t a business become a penny stock because no one wants it?
The majority of penny stocks on Robinhood will not make good long-term investments. They will be incredibly risky and may never increase in value. However, there may be some opportunities for advanced traders to capitalize on short-term fluctuations and make a quick profit.
As with all investments, it’s important to know both the pros and cons so that you can make your own informed decision. That’s why in this post, we’ll explain what a penny stock is, why they continue to fascinate investors, and what the possible risks are in trading them.
What Is A Penny Stock?
Despite the name, penny stocks don’t actually trade for a penny. The U.S. Securities and Exchange Commission (SEC) defines a penny stock as a security that trades for less than $5 per share.
Generally speaking, penny stocks are usually small, relatively unknown companies with a market capitalization between $50 and $300 million (also called “micro-cap” stocks). However, just like GameStop and AMC, there have been many instances throughout history where behemoth companies got into financial trouble and fell into penny stock territory.
For instance, during the Great Recession of 2008, the shares of automotive giants GM (General Motors) and Ford fell below $5 and became considered penny stocks. To many, it was a symbol of just how bad things were at the time with the economy given that both of these companies had dominated the vehicle industry for the better part of the century.
Why Share Price Matters
In the normal spectrum of stocks, a share price is somewhat arbitrary. Big companies like Apple will often split their stock prices and simply issue more shares. So in essence, it doesn’t really matter if the share price is $50 or $500.
However, if the share price drops too much, its market capitalization may eventually get too low. The company might then struggle to meet the criteria to stay listed on one of the major stock market exchanges such as the New York Stock Exchange (NYSE) or NASDAQ.
While some penny stocks can be sold on the major exchanges, the majority of them will have to use alternative trading platforms like the over-the-counter bulletin board (OTCBB). Stocks that sell over the counter are not subject to SEC regulation, so there could be some opportunity for sketchy behavior.
The OTCBB is also called the “pink sheets.” Fun fact: The name pink sheet comes from back in the days before computerized trading when a stock’s price quote would be printed on actual pink slips of paper.
What Makes Penny Stocks Risky?
There are three main issues with penny stocks:
- Lack of transparency. When a company is not required to submit financial information to an oversight agency like the SEC, investors have no real mechanism to ensure its transparency. Even if they do release some financial information, it could potentially be manipulated or even fraudulent.
- No fundamentals. Classically, most people will invest in a company because of strong fundamentals using metrics such as the price-to-earnings (PE) ratio or earnings-per-share (EPS). However, without any financial transparency about the company, investors wouldn’t be able to use these kinds of metrics. At best, they’d have to rely on the media for recent news about the company, which could also easily be paid for, manipulated, and misleading.
- Pump and dump schemes. A pump-and-dump scheme is when someone buys shares of a company, misleads others to buy them by hyping up the company’s potential, and then sells their shares after the stock price goes up.
Anyone who’s seen the 2013 movie “The Wolf of Wall Street” with Leonardo DiCaprio is already familiar with how a pump and dump scheme works. DiCaprio’s real-life character Jordan Belfort sold stocks on the pink sheets that he and his business partner Danny Porush already owned to unsuspecting clients convincing them that they were these incredible investment opportunities.
However, after the stock price would rise, the two would quickly sell off their shares and leave their clients with essentially worthless securities. To add insult to injury, they also charged ridiculously high service fees for brokering these transactions.
Although Belfort’s activities took place throughout the 1980s and 90s, pump and dump schemes are still very real today. In 2021, a team of anonymous developers launched and hyped a crypto token called “Squid Game” named after the popular Netflix show. However, the whole thing was nothing more than a classic pump and dump scheme that enabled them to defraud investors of over $12 million.
Why Do People Invest In Penny Stocks Then?
If penny stocks are so sketchy, why on Earth would people want to buy them?
The reason people trade penny stocks is that it doesn’t take much to make a quick buck. Whereas regular large-cap stocks might produce a 10 percent return for the entire year, penny stocks have the ability to double or even 10X their returns – and in a relatively short amount of time.
To illustrate how this works:
- Let’s say you buy a stock for $1 per share.
- If that stock even goes to $1.50 or $2 per share, you’ve made a 50 to 100 percent return.
- If some positive news comes out that the company will release a new product or has new leadership, then it could send the share price soaring to $10. Now you’ve made a 10X return!
This is exactly why there was so much frenzy around the GameStop stock. Throughout most of 2020, the stock was trading below $5 per share. However, by January 2021, the share price climbed to a peak of $325.
Several people who had invested just a few thousand dollars became millionaires in just a few short months, and amateur investors have been looking for the next big penny stock ever since.
Another thing that fuels penny stock trading is how cheap they are. Since they cost less than $5 (with many selling under $1), the investor can spend a few hundred dollars to buy a relatively large number of shares. Even though they’re essentially gambling, it’s a chance they’re willing to take.
Are Robinhood Penny Stocks A Good Investment?
Despite the dangers of trading penny stocks, it’s perfectly legal for a platform to offer them. Since Robinhood offers any security listed on the NYSE or NASDAQ, users will find hundreds of different penny stocks that still meet the qualifications to be listed on these exchanges.
… But does that mean investors should buy them? To judge for yourself, let’s review the potential pros and cons of investing in penny stocks through Robinhood.
Pros
Here’s how trading penny stocks on Robinhood could be beneficial.
No trading commissions. One of the things that really fueled the stampede of investors willing to buy GameStop and AMC was the fact that trading apps like Robinhood don’t charge commissions for trades. Unlike the 1980s when brokers like those in The Wolf of Wall Street charged hundreds of dollars per order, Robinhood makes its money in other ways. This essentially lowers the risk of loss for investors to virtually nothing beyond the cost of the security itself.
SEC-regulated companies. If you had to rank penny stocks from most reputable to least reputable, the top of the list would be those that still meet the qualifications to be listed on the NYSE and NASDAQ. Since Robinhood doesn’t deal in over-the-counter stocks, investors can have some level of confidence that these companies follow SEC regulations.
High reward potential. For many people, even if there’s a one percent chance that a penny stock might double or quadruple in price, then the inclination to gamble on it can be extremely powerful. One way to look at it is that if someone was planning to spend $100 at the casino or lottery tickets, they might actually have better odds buying a SEC-regulated penny stock and setting a market order to automatically sell it once it grows by a certain percentage.
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Cons
Relative to other investment strategies, there can be some major drawbacks to buying penny stocks. Here are a few that investors should be wary of.
Extreme risk. Again, we can’t understate how risky penny stocks are. Even with SEC-regulated companies, the majority of these companies will simply have no long-term viability. There is the possibility that the share price may drop down even further and never recover, or that the company just dissolves.
Illiquidity. One thing most investors take for granted in the stock market is that they can sell anytime they wish. This is because with shares of well-known companies like Apple or Amazon there’s always a buyer willing to take them off of your hands.
However, this is not true for penny stocks. Virtually no one will know who these companies are, and so even if you’re ready to sell, there may not be a buyer on the other end. That can create a problem with illiquidity, and there’s a potential that the price could sink even lower while you wait for someone to take your shares off your hands.
Complex trades that result in amplified losses. While Robinhood offers many advanced features to its users like trading on a margin and shorting stocks, these techniques can be dangerous in the hands of the inexperienced and even amplify their losses. In fact, for one young man, it unfortunately resulted in death.
In 2020, a 20-year-old college student was using the trading app to execute some of these advanced trading strategies. Even though he believed he knew what he was doing, it resulted in a negative balance of $730,000. Tragically, the young man was so traumatized by what had happened that he felt his only escape was to commit suicide.
Ultimately, Robinhood settled the matter and made some serious changes to its product offerings and user requirements. However, this story serves as a cautionary reminder that investing can take a very dark turn if you’re not careful.
How To Buy Penny Stocks On Robinhood
Traders who understand the risks of penny stock investing and would still like to move forward can easily find them on Robinhood. If you already know the name of the stock you’d like to purchase, then you can simply type it into the search bar at the top.
However, if you’re unsure about what’s available or would just like to browse the available options, then here’s what you can do.
- Unfortunately, browsing penny stocks is a little difficult from your smartphone due to the screen size. Therefore, try using your desktop or laptop.
- After logging in, scroll down below your portfolio to a section called “Trending Lists”.
- Click on “Show More” to expand your options and choose one of the major stock categories such as “Energy”.
- Click the “Filter” icon and adjust the maximum price to $5. The list below will now only show penny stocks currently trading on the NYSE and NASDAQ.
- To investigate other options, go back to the home screen and repeat these steps for one of the other major categories.
How To Buy Penny Stocks On Robinhood
Once you’ve found a few penny stocks that you’d like to buy, the process will be exactly the same as buying any other stock on Robinhood. Select the type of order you’d like to make (i.e., market, limit) and place it.
For most penny stocks, you’ll only have the ability to order by the number of shares you’d like to buy. However, some might also give you the option to buy according to a specific dollar amount (which may result in fractional shares). Given the potential for illiquidity, I’d recommend using the “shares” option to avoid potential issues with trying to sell fractional shares later on.
Beware – Use Caution When Penny Stock Investing
Again, I can't stress enough how risky penny stock investing can be. It can be easy to convince yourself that all you have to do is buy $1,000 worth of a stock that costs $0.10 per share, wait for the price to go up to $10, and you'll have made an easy $100,000. But that rarely ever happens.
The people who actually do well with penny stock investing understand technical analysis and how to predict short-term market fluctuations. If this is not something you're willing to learn and spend time getting good at, then buying penny stocks will be nothing more for you than gambling.
What's worse is that if you try to take a shortcut and follow the advice of some investment guru, then be prepared for disappointment. These talking heads are rarely ever right, or in the most extreme cases, they might be trying to lure you into a pump and dump scheme.
For the majority of people, the smarter choice is to invest for the long term. Buying the stocks of large-cap companies that have proven their viability is a much, much safer approach. Investors can make their jobs even easier by purchasing shares of an index fund and capturing the overall performance of the entire market.
Whenever I think about investing in the stock market, I think of this quote from investment master Warren Buffett, “If you don't feel comfortable owning a stock for 10 years, you shouldn't own it for 10 minutes.”
Should You Invest In Robinhood Penny Stocks?
For years, penny stocks were considered to be companies that were in financial distress or the tools of fraudsters like those in The Wolf of Wall Street. However, the run-up by two former penny stocks GameStop and AMC has many investors wondering if any others on Robinhood may be a good investment.
According to the SEC, a penny stock is any stock that has fallen below a price of $5 per share. Although most of these stocks will be from relatively unknown companies, some major businesses have tumbled from grace and entered into penny stock territory.
The allure of penny stocks is that a small jump in price can result in a potentially huge gain. Plus, these stocks are cheap and cost nothing to trade when using a commission-free trading app like Robinhood.
However, investors need to be very careful when browsing potential penny stocks on Robinhood. These companies are often in some kind of financial distress or not being competitive within their industry. This means there's little opportunity for long-term growth and may even create illiquidity for the shareholders.
In some cases, penny stocks may even be the tools of scammers. There have been many cases of “pump and dump” schemes where a financial guru will convince people to buy the shares of stocks they secretly own. After the price rises, the guru will sell their shares for a profit leaving everyone else with a worthless investment.
Again, penny stock investing is a short-term strategy. Most investors would be smart to take a long-term approach and put their money into reputable companies that will maintain their value for years to come.
Penny stock investing should only be done if you understand the risks and are willing to put in the time to become an advanced and experienced trader.
