Penny Stocks | What are they exactly?

When diving into the trading side of the world, the first thing that you are going to come across is shares of stock at many different prices. The prices could range from a couple of bucks a share to a couple hundred thousand bucks (Berkshire Hathaway Class A stock, for example, is worth over $342,000 per share as of Jan. 2020.) However, the price itself is not indicative of how good the stock is that you are investing in.

The price of the stock is directly linked to its companies market capitalization (how big the company is), and not necessarily to the day to day performances, although they could affect the price as well.

For example, if a company is worth 1 million dollars and has 1 million shares outstanding, then the stock will trade near $1 a share. However, if that same company that was worth 1 million dollar had 1 thousand shares outstanding, then the shares would be worth nearly $1,000. In both scenarios, the company is worth the same, it is simply the way of calculating it that changes.

So what does this have to do with trading?

Not much in terms of price. But trading is mostly about volatility.

Volatility is the liability to change rapidly and unpredictably. 

Or in English, volatility simply means the likelihood for the stock price to change

The more volatile a stock is, the more aggressive the upswings or downswings tend to be. Traders tend to like more volatile stocks because they offer more potential for profit. However, there is such a thing as too much volatility. Once a stock is too volatile, then the riskiness of putting your money into that stock to try and trade goes up exponentially. The most volatile and unpredictable stocks in the market are known as penny stocks.

The definition for penny stocks, on the other hand, refers directly to the price of the stock. Before 2008, these stocks were defined as the stocks of small companies that are trading at less than $5 per share. While most large companies won’t come near this number, there are still some situations where a large company goes through several stock splits that cause their price to dilute. We will go more in depth into stock splits later on in this chapter. 

An example of this would be Ford Stock. As of January 2020, Ford’s stock is trading between $8-$9 a share, but it has a market cap of over $33 billion. Ford would not be considered a penny stock.

Penny stocks are probably the most popular style of stocks for new investors to get into for all of the wrong reasons. 

Reason #1: They are cheap. 

Cheaper does not always mean better. There is a fine line between having enough volatility to trade and have too much volatility to the point where the stocks become illiquid.

(Liquidity refers to the ability to buy and sell at any given price point. Stock that are less liquid have less buyers and sellers, and thus have a harder time of getting in and out of positions.)

Reason #2: They are praised for making the most millionaires.

I do not disagree that if trading penny stocks is your niche, then you should go for it. However, for the majority of people, penny stocks are simply too risky to be considered as a consistent form of trading income. When you get down to trading stocks that are worth less than $5, I found in my personal experience that it was more of a gambling scenario than an educated trade based on technical analysis.

Reason #3: People just don’t know any better

When I first started out, I was the exact same way. I just didn’t know that there was a difference between penny stocks and stocks of companies like Google or Apple. Once I began to do my own research on the factors of the stock market, I was able to find a niche in the stock area that I was investing in, in order to maintain the highest level of consistency.

If you want to learn more about getting started trading in the stock market, I recommend you read this article:

The Most Basic Concept Every Stock Trader Should Know

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