Trading stocks is associated with building wealth and long-term investing. But what about penny stocks? And specifically, are penny stocks on Robinhood any good?
What Is A Penny Stock?
A penny stock is an asset that represents smaller companies. The value of a single share of that asset usually comes at a price below $1 all the way up to $5.
Rarely are penny stocks traded on the NYSE. They are commonly traded over-the-counter (OTC) through an electronic exchange. This can be through the OTC Bulletin Board (OTCBB) and occasionally through private OTC market groups.
The volume of penny stock trades is significantly less than the major company trades. This causes the potential illiquidity of funds. The lack of liquidity leads to large fluctuations in price quotes due to its highly speculative nature.
The company size being small generally relates to a higher risk of insolvency or bankruptcy. This leads to a higher risk of losing your entire investment in that company.
The lower price of penny stocks carries a significant upside for investors. The significant benefit of a penny stock is the potential for exponential growth that would beat the common market trends.
Keep in mind that penny stocks are considered a risky investment. There is underlying uncertainty associated with smaller companies. On occasion, stocks will make it big and end up getting listed on the NYSE or Nasdaq.
Why Are Penny Stocks On Robinhood Risky?
The risks associated with investing are commonly related to penny stock purchases. These risks include but are not limited to insolvency, growth, inflation, and interest rate.
An important additional risk with purchasing penny stocks is fraud or scams. The following are different types of scams that are common with penny stocks:
Pump and Dump
Easily one of the most common scams with penny stocks. A promoter will purchase a large position in the stock. They then start to drum up interest through a variety of social networks or ads to inflate the stock price.
Once inflated, the promoter will sell all their holdings at a significant profit. The investors end up taking a huge loss. It works due to the relatively small volume being traded.
Short and Distort
This is the opposite of the pump and dump scam. The investor is betting on the stock falling, so they will borrow shares from a broker. They then sell them on the open market. Typically, they’ll start a slander or FUD (fear, uncertainty, doubt) campaign against the company.
By doing so, they lower the price of the stock relative to the price they borrowed at. Then they pocket the difference from the short sale.
Precious metals and energy products are hot commodities that have a significant allure. Company owners will make false claims about the discovery of these commodities, which then boosts their company value. Once company shares rise in value, the owners sell out a significant portion of their shares. The company collapses and investors lose all their money.
No Net Sales
The person running the scam will offer stocks with a no-sale period due to high demand for the stock. Once the scammer receives the money, the shares are worth less than the purchase price. The shares no longer have demand. This scam takes a long time to shut down, and investors typically lose their money.
Companies that are not based in the U.S. do not have to register their shares or file financials with the SEC. The scammers will purchase cheap unregistered stocks, upsell them at higher prices, and run off with the excess in profits. This leaves the investor with little to no money left. This is a very important one to watch out for if investing in a foreign entity on the AMEX or OTCBB exchange.
Keep in mind as with all things in life: If it’s too good to be true, it probably is.
Is Robinhood Good for Penny Stocks?
Robinhood offers a variety of opportunities to purchase penny stocks on the platform. The investment options are strict with only penny stocks listed on major exchanges such as the NYSE and Nasdaq. The OTCBB is not an available exchange on Robinhood.
That means the full gambit of penny stocks is not available on this platform. And that’s not necessarily a bad thing as it limits risk for many beginner investors.
Robinhood is a good app for trading penny stocks on major exchanges. With commission-free trading, the company offers value in the cost market. Penny stock growth may be significant over a short period, and to pay commission getting into the stock and out quickly diminishes any gains earned.
The only disadvantage of using Robinhood is that the OTCBB is not an exchange option. The OTCBB houses a lot of the stocks that trade below $1 and have significant potential for growth upside.
Reviews on Robinhood are positive with around 3.5 out of 5 stars.
The biggest complaints revolve around education. Robinhood offers the full gambit of investing options, including margin. Novice investors may find themselves over their heads if they do not understand the advanced features.
The positive ratings revolve around cost. With no commissions, the costs are low for entering the stock market. The average Joe can join in on trading at any time.
Factors To Consider With Penny Stocks On Robinhood
Deciding on an investment requires lots of research and consideration. Penny stocks on Robinhood are different in the types of considerations necessary to delve into. Let’s look into a few of these considerations:
All stock investments carry risk. There are no guarantees. Typical risks are inflation, insolvency, liquidity, interest, political, and the market.
Penny stocks amplify the type of risk being taken on due to the small business nature. Insolvency is a common risk with penny stocks considering most of the companies are startups. They are generally using the share listing as a means of bringing in capital.
Individual risk aversion is important to consider before purchasing penny stocks. Investing a significant sum of money in penny stocks is a gamble. Follow the mantra of “don’t keep all your eggs in one basket” when purchasing penny stocks.
Trading volume is important when purchasing stocks. The higher the volume, the more likely a trade will actually execute when selling.
Penny stocks do not have high volume trading. An order could stay open for a long time before being filled. This could lead to slower cash flow and potential losses, depending on when the trade is able to execute during an open market sell.
3. Company History
Typically penny stock companies do not have a long financial history. Some companies are startups looking for additional capital to make the push into larger realms. Others are perpetually looking for funding to keep afloat.
Though it may prove difficult, taking the time to research the company is important. This shouldn’t come as a surprise. As with all things in life, the more effort you put, the higher likelihood of success. It’s what separates the sheep from goats.
Fraud is rampant with penny stocks and may cause significant losses.
Pump and dump schemes are a common fraudulent practice. Another common scheme is the pyramid scheme. Cons will set up multiple shell companies to show fake profits to trick investors into putting up money. Once the criminals have grown enough value in the shell company, they declare bankruptcy and take the money.
5. Growth Expectations
With any stock investment, it is important to set realistic expectations. This is no different with penny stocks.
Once an investment is made, an exit plan is necessary to offset losses or take gains. The tax implications may be significant if the gains are realized in less than a year.
To this end, if the growth happens, a plan to offload significant amounts of shares needs to be considered. It may be difficult to offload large quantities of penny stocks at once, so scaling out may help.
Robinhood Penny Stock Trading Strategies
The right stock is out there for everyone and having a strategy for picking helps. Understanding the risks before purchasing a penny stock on Robinhood is important. We recommend following these strategies to help mitigate those risks.
1. Research the company
- Quality of Management – the owner of the company and their track record is important. If they’re well known and have a proven history of transforming businesses it may be fit for purchase.
- Financials – reading the company profit and loss statement is an integral habit. Typically, the first year comes with a loss due to the significant up-front costs. However, multiple years in the loss column may be a red flag.
- Disclosure – the transparency of the company is important. Any information fed to investors and financial institutions drives investment decisions.
- Business Plan – the overarching market plan for the company. Understanding these trends and outlook is important. Investing in a company that doesn’t have a solid potential growth model is doomed to fail.
- Time in business – the amount of time a company has been running is important to look at. Quickly set up companies may be shell companies, and fraud is a foremost concern.
2. Entry and Exit point
When investing in any stock, a plan of attack is important. Be sure to set a stop loss to minimize losses.
Deciding when to exit is just as important as when to enter into a stock. Set a profit target and walk away once it hits. Emotions should have no bearing. Fibonacci retracements and extensions may help keep profit targets objective.
3. Short or Long Hold
Tax implications are on the line with the length of hold on a stock. Holding for less than a year will incur a higher tax rate. On the other hand, holding a stock for a year or longer incurs less taxes on the gains.
If selling a position with a short hold period, make sure to consider the extra taxation on it.
4. Trading Volumes
Review the stock volumes for the past few weeks. Stocks trading at a higher volume will have better liquidity than stocks with minimal volume. This helps guide the entry and exit strategy. However, if the volume is way higher than usual, be careful, since it could be a momentum trade. These sudden movements in volume usually come crashing back down in price.
5. Risk Aversion
All individuals have different risk tolerances. Understand the risk in a penny stock before purchasing. Invest only what you can afford to lose. Penny stocks are inherently riskier due to their volatility, be sure not to overextend your investment, plenty of people have lost big chunks of their money not managing their risks properly.