Penny stocks get a lot of hype. A lot of educators like to show off their massive gains of 3,000% returns with penny stocks. Most of these claims are a total lie. While it is possible to make large gains quickly with penny stocks, they aren’t the best vehicle to go about accomplishing that goal. We’ll go over the issues of penny stocks and some alternatives in this article.
This article assumes you understand the risks of trading and all that jazz.
What Are The Advantages of Penny Stocks?
The term “penny stock” is a bit of a misnomer, as the term really can apply to any stock under $5. The main advantages to penny stocks is that you can buy more shares of a stock, and thus make more as the stock goes up or down.
If you buy 1,000 shares of XYZ stock and it goes up $1, you made $1,000 in gains.
For most small traders, it’s difficult to buy a lot of shares of most mainstream stocks like AAPL, which trades for around $175 per share.
However, not only can you buy more shares at lower prices, but penny stocks are way more volatile than mainstream stocks, such as AAPL. AAPL might move up or down 1% on any given day. Penny stocks move anywhere from 2-5% on any given day.
The more volatility a stock has, the more opportunity to make money faster.
Volatility? That’s It?
Essentially, yes. The 2 biggest advantages to penny stocks is that you can buy more shares at lower prices, and penny stocks move more. But to focus on these 2 advantages would be to forget the major pitfalls of penny stocks.
Penny stocks are subject to pump and dumps. For those of you familiar with the Wolf of Wall Street, this is exactly what Jordan Belfort did at his firm Stratton-Oakmont (Which is coincidentally the only illegal thing he did).
For those of you involved in penny stock chatrooms and online threads, it isn’t uncommon for a moderator to talk up a penny stock to gain virality through those mediums. What is the point of a moderator talking up a penny stock? So that it goes up of course (read: pump and dump).
Not only that, but who wants to sit around all day reading about small “could-be” companies. The line between trading and gambling becomes really thin, really quick when you’re looking for the next big thing.
By the way, don’t get me wrong here. I’m not demonizing gambling, like some others would. I’m just pointing out that your odds of succeeding at it are very small, and that your metal resources might be best suited elsewhere. Like with this…
Here’s Something More Reliable…
Options on well-known stocks, and Futures. (Get the Bean? Futures… Chicago… CME… Get it?)
Options and Futures are meant to be hedges for business and investors. However, there has to be someone else taking the other side of the hedge. These people who take the other side of the hedge are known as market-makers, specialists, speculators, or traders (for short).
They’re More Popular Than Penny Stocks
Here’s the thing, these professionals who take the other side of people’s trades wouldn’t do so unless it was reliable and profitable. Yes, or yes? Yes.
This where you potential penny stock traders should ditch the idea of trading penny stocks, and consider Options and Futures.
You want to follow the money. Where there’s money, there’s liquidity. Options and Futures are much more liquid than penny stocks. This is a huge advantage that should not be overlooked. More liquidity allows for you to trade larger positions (if your account permits you to do so), and you won’t lose as much on the Bid/Ask spread.
The odds of AAPL dropping to $0 per share any time soon is very, very small. In other words, when you choose large, well-known stocks to have on your watchlist, you’re most likely going to have them on your watchlist for a long time.
You won’t have to be constantly looking for new companies to trade. Instead, you can focus on refining your skills that really matter such as Fundamental and Technical Analysis, and Tape Reading.
Most highly skilled professional traders only focus on a few stocks/futures markets. Why? Because each stock/futures market has a certain set of characteristics that influence how it trades. It’s better to be the master of a few markets/stocks, than trying to trade everything.
Options And Futures Still Provide Large Gains (If Not Larger)
Options and Futures provide leverage. Leverage can amplify your gains, but it can also destroy your account if you misuse it. Check out this article for the best practices on using leverage.
With penny stocks, you’re essentially using leverage, albeit in a very inefficient way. Think about it, you’re trying to use more shares to trade by trading lower priced stocks. When using leverage on a larger stock, you’re borrowing money from your broker to trade more shares of stock. See what I mean?
Options and Futures are inherently leveraged products, because they are derivatives. Don’t let that word “derivative” scare you. It just means that the value of the Option or Future is derived from an underlying product.
For more on how Options work, you can check out this free resource.
Options And Futures Are Less Manipulated
Jordan Belfort? Hello??
This is hands-down probably the most important reason to ditch penny stocks and become proficient at Options and Futures. Options on large stocks, and Futures are difficult to manipulate. They are also “thicker” markets, so they aren’t as erratic as penny stocks.
For instance, take the E-Mini S&P 500 Futures, otherwise know as the /ES. The /ES has a very distinct personality to how it trades. It tend to be very choppy with smaller ranges than something like the NASDAQ Futures (/NQ).
If you’re more of a laid back trader who likes to sit in trades, or a faster trader who scalps ticks here and there, knowing the personality of the product you’re trading puts the odds in your favor. The point here is that things trade differently. Each product has its own personality to it, if you will.
If you’re constantly changing up the stock/future you’re trading, then you have to reset your expectation of the probabilities. The fact that Options and Futures are less manipulated lets’ you keep your expectation of the probabilities consistent. With a consistent expectation of the probabilities, you’ll likely make more money over the long run.
Don’t Forget About The Pattern Day Trading Rule
Let us not forget the single most stupid regulation in existence… the Pattern Day Trading Rule.
For those of you who are not familiar with the PDT, it’s a FINRA rule that says if you have less than $25,000 in your trading account you cannot make more than 3 day trades within a 5 day period. Once you have more than $25,000 in your trading account, you can make as many trades as your heart desires.
Why is this regulation so dumb you might ask? Let’s first consider the line of logic here. The idea behind this regulation is that it prevents retail traders from “overtrading”, and thereby spending too much in brokerage fees. The reason why it’s dumb is that if you were to make 4 day trades, you would be stuck in an open position with that 4th day trade.
What happens if the market moves severely against you? You could hedge it, but most retail traders probably wouldn’t think of that in the heat of the moment.
If you’re a penny stock trader, odds are you probably don’t have $25,000 in your trading account and you will be subject to the PDT rule. However, if you were to cross over to the realm Futures trading, voila… there is no Pattern Day Trading rule. Yet another reason why Futures are the best trading product available (with Options coming in a close second).
There you have it. Hopefully, this article has beaten some sense into you. The claims of making it big as a penny stock trader are lies. Does Ray Dalio trade penny stocks? Paul Tudor Jones? Warren Buffett?
Nope. Then why should you?
If you want to amplify your gains, quit playing silly games. Get serious, and learn to trade Options and/or Futures.
Thanks for reading. Leave us a comment if you’d like to continue the conversation further.