Dylan Lewis: We get questions all the time
on YouTube about one topic in particular. In this FAQ video, we’re going to break it
down. I’m Motley Fool editor Dylan Lewis, and today, we’re going to be talking about how
people trade penny stocks and why they shouldn’t. We get this question a lot because there’s no shortage of people online talking up day trading.
A quick search on YouTube, and you’ll find an endless stream of videos with some
guy smiling in front of a computer and a bunch of charts on the screen, and he’ll promise
you he can teach you how to make thousands of dollars from anywhere in the world.
It sounds amazing, but it’s largely bunk. The problem with day trading penny stocks is that it
combines two of the most destructive investing pitfalls: one, trying to time the market,
and two, buying stocks instead of businesses. A lot of our videos talk about the difficulty
of trying to time the market — that is, to read technical indicators to try and buy stocks
at the absolute bottom and sell them at the absolute top. Day trading takes market timing
and puts it on steroids, because all your buy and sell decisions are made daily or hourly
based on stock price movements. On top of the issues that come with timing the market,
day traders are often paying fees on every single transaction. Even if trades are profitable,
they come with $5 to $7 brokerage commissions. Oh, and because day trading tends to dominate
time in hours, days, and weeks, most the gains investors earn are taxed at the short-term
capital gains rate, aka your standard income rate, which is between 10% and 37% for most
people, instead of the more favorable tax rate investors get for holding
an investment long-term, 0%, 15%, or 20%. But you would be lucky to even have profits
to tax with penny stock day trading. In the mid-2000s, a group of academics studied the
activity of day traders on the Taiwan Stock Exchange. They found heavy day traders earned
gross profits, but their profits are not sufficient to cover transaction costs. Moreover,
in a typical six-month period, more than eight out of 10 day traders lose money. The researchers
closed with saying, “Prospective day traders should be apprised of their likelihood of
success: only two out of 10 make money, and fewer do so consistently.”
Market timing is hard, which is why so few people are able to do it and make money consistently.
Add to that the seedy elements of penny stocks, and it becomes even harder to make money.
The world of penny stocks is rife with speculation and hearsay, and these stocks tend to move
more on buzz than on core business fundamentals. That’s because penny stocks are generally smaller,
less established companies that have market caps, or total business value, of less
than $100 million, and shares priced below $5. They often trade OTC, or over the counter,
meaning they aren’t traded on major exchanges like the New York Stock Exchange or the NASDAQ.
This means that the companies don’t have to go through the more rigorous reporting requirements
established by these major exchanges, and that shares are less liquid. Liquidity is
kind of a squishy concept, but basically, a less liquid stock will move more dramatically
when any one person tries to buy or sell it. Now, penny stocks often catch the eye of new
investors because the shares don’t cost a lot of money and because the low share price
makes big returns so easy to imagine. It doesn’t seem too far-fetched for a stock currently
trading at $0.10 to be worth $0.30. And with only $100, you could buy 1,000 shares.
The reality is, those shares are probably priced at $0.10 for a reason. Most penny stocks are
unproven businesses with limited operating history, and many of them don’t have tangible
products or profits to show investors. They trade over the counter because they
operate on the margins of our financial markets, which makes them a rich area for fraud
and manipulation. In a best case penny stock scenario, you might be trying to buy an unproven company that
hasn’t been vetted by analysts and exchanges. In a worst case scenario. You could be a sucker
for pump-and-dumps schemes. Penny stock promoters will talk up little-known companies worth
only a couple of million dollars and blast online forums explaining the business is working
on game-changing technology that can make the company worth 100X what it currently is.
Before they do this, they’ll buy shares, then enjoy the ride up as new investors bid up
the stock price. Then, the fraudsters will cash out and make money. Their followers will
be left holding shares of a company they don’t know anything about, and with the fake hype
gone, the shares will drop back down to their previous lows. Penny stocks
and day trading are one of those situations where two negatives don’t multiply
to make a positive for investors; they add to create an even bigger loss. Instead of
market timing and buying up obscure companies, investors are far better off buying mutual
funds or companies that have gone through the vetting and disclosure process of listing
on a major exchange like the NASDAQ or the New York Stock Exchange. Start out with
businesses whose products you interact with every day and understand on some level. Maybe there’s
a software you use for work, or a social media platform you always seem to be checking, or
an e-commerce company that seems to be your go-to shopping destination. The businesses
you know best are a great place to start your own investing research.
If you want a hand with your homework, we have an investing starter kit. It goes through
all the things to look at before buying a stock, and it also takes you through the money
checklist to make sure you’re actually ready to start investing. You can
get that over at fool.com/start. That does it for this FAQ video! If you have
a topic you’d like to see us talk about, drop it down in the comments section below.
Please give us a thumbs up and be sure to subscribe. I know it seems ridiculous, but these are
the little things that help us reach more people, which lets us make
more content like this.