Other Risks for Penny Stock Traders
Besides the single biggest risk for penny stock traders, there are other common pitfalls to watch out for and risks that you should be aware of. The good news is that we can help you avoid many of these risks.
Risks Specific to Penny Stocks
Low tradability, low visibility, hype, delistings, dilution, equity risk, market risk...
Low Visibility: The company does not furnish regular financial reports. The lack of transparency makes it tougher to make great investment decisions, and also increases the likelihood that there will be reporting and information issues.
The Solution: Stick to trading penny stocks listed on the premiere exchanges (Nasdaq SmallCap, Nasdaq National, AMEX, and some OTC-BB. Avoid most OTC-BB and all Pink Sheet stocks). The larger and more established markets have higher requirements with regards to financial reporting.
De-Listing: If a stock does not meet the requirements of the exchange that it is traded on it will be at risk of being de-listed from the exchange. For example, the NASDAQ has requirements for the minimum annual avg. trading volume, minimum stock price over a given period of time, and company cash flow over a 12 month period (not all requirements must be met in all scenarios).
Typically, any time shares get delisted, they drop down to a lower exchange and trade there. For example, if a stock is not meeting the NASDAQ listing requirements, they will often get "bumped" down to trade on the much smaller Bulletin Board exchange.
You would still be able to buy and sell the shares, and the annual exchange fees and reporting requirements would be much lower. However, there would also be much less visibility for investors and analysts, many of whom never look at and company which is not trading on a major exchange.
When companies keep dropping, they can potentially be delisted from any exchange, in which case they trade "over the counter," or not at all. Either scenario is typically bad for investors, and is often the sign of a sinking company.
Solution: Avoiding ownership of shares that may be de-listed is something that is inherent with picking great stocks. If the companies that you invest in are performing well, de-listing is not something that you will likely have to worry about.
Dilution: This occurs when new shares are issued by a company. This is different than a stock split because the shares are not just given to existing investors. The value of each existing share is reduced when the shares are diluted, and the value of your total holdings in a company are also reduced.
The Solution: Just as is the case with de-listing, there is a limited amount that can be done in order to avoid being diluted. The best advice to avoid dilution is to invest in great companies that are unlikely to be in a position where they need to raise more money beyond their IPO in the future.
Low Tradability: This means that a stock trades very few shares per day, and there is little investor interest. The lower the volume is, the tougher it will be to sell your shares at a price that you want to sell them at.
The Solution: Focus on higher volume penny stocks, or those with greater investor interest. You can tell by daily trading volumes if a stock may be problematic. Look for at least 20,000 shares traded per day, but the more, the better.
Here is an example of a stock that has a relatively high trading volume when compared to other penny stocks. The screen shot below shows the data for SiriusXM (SIRI) which has an average daily trading volume of approx 36 million shares.
Creative Learning Corporation (CLCN) is a great example of a company whose shares trade at a very low volume. If you are evaluating a stock trade in this company, you would want to consider the fact that the shares are not as liquid and it might be tougher to capitalize on a small increase in bid/ask prices.
Stock Hype: How do you know what information to trust? Companies have been known to 'exaggerate' their situation. There are also promoters out there of all kinds that will try to hype a particular stock just to enhance their own trading position, and sometimes simply because it is their job to promote a stock.
Solution: Make sure you do your own due diligence on the companies, or get leads about great penny stock companies from a proven newsletter or service. The best scenario involves doing your own research on penny stocks that you have been alerted to through a professional service, and only getting involved after you have looked into the company.
One of the aspects of our business here at peterleeds.com is that our core values are largely derived from our unbiased guarantee and our committment to help our subscribers make money.
General Stock Trading Risks
These risk factors are not as specific to trading penny stocks. You will have to deal with these factors no matter what type of stocks you trade.
Suspension of Trading: This can happen for a number of reasons. Sometimes this can be because of a major incident in which case the shares might be suspended just to prevent the stock price from being unnecessarily destroyed while investors decide how the shares should be priced.
When trading is suspended, it is often only for a short period of time. However, this is not always the case. Once trading is suspended this means that you won't be able to sell your shares to close out the trade, or you won't be able to buy more shares in order to take advantage of a potential opportunity.
Market Risk: It's a crazy world out there and investor sentiment plays a huge roll in stock pricing. If the Federal Reserve decides to raise interest rates - this can have a direct cascading effect in many industries and usually will affect investor sentiment overall as well. If an oil refinery in Saudi Arabia explodes, this will affect oil prices which in-turn will affect companies whose profitability correlates highly with oil prices (like tire manufacturers). An economic depression can also have a market-wide effect of stock prices. Virtually everyone who trades in stocks is exposed to market risk.
Did You Know?
Most losses penny stock traders endure, and the majority of mistakes, can be easily avoided. In fact, by familiarizing yourself with the pitfalls, you can quickly protect yourself from the risks.