Penny Stock Risks: Liquidity, Volatility and Pump-and-Dump Schemes

What Counts as a Penny Stock

Penny stocks are said to be the stocks that trade at the value of less than $5 in USD. In particular, the SEC defines penny stocks as any equity security that has a price of less than $5.00 per share and is not listed on a national securities exchange, subject to certain specific exclusions.The majority of penny stocks are traded outside the major exchanges like NYSE and Nasdaq and thus have varying information disclosure practices and transaction methods.

Finding the best penny stocks to buy will usually result in finding a list that revolves around one factor - the price. Price cannot tell you anything about the company’s market cap, liquidity, and even if the company is real or not.

Penny Stocks vs Microcap Stocks

These terms can be used interchangeably, but they measure different things. While penny stock is based on the stock price, a microcap stock is based on market capitalization. Microcaps have a market capitalization of less than about $300 million. There may be a microcap company that trades for more than $5 per share, and there may be a penny stock for a company not considered a microcap.

This is important since trading on the stock exchange requires more extensive reporting than the majority of over-the-counter stock symbols, meaning that there are fewer opportunities for traders to verify information.

Step 1: Check Trading Volume and Liquidity Before Anything Else

Liquidity makes it possible for you to close your position for an affordable price, which has to be checked even before looking into the story of the stock, and a stock with an inadequate average daily trading volume could be easily entered but hard to exit, given that a high sell order in a thinly traded market lowers the price against the seller.

It could be sensible to gauge the size of the position that you want in relation to the daily average volume of the stock rather than just judging from its price. Here is an average daily trading volume analysis on how this metric works and why it is important, which applies to any stock, not only penny stocks.

Step 2: Measure Volatility With a Real Example

Imagine there is a company whose shares are trading at $0.80. One day, there is an enormous buy on the stock and it moves to $1.60, up 100 percent. However, the very next day, there is a heavy sell-off and the stock price declines to $0.90. An investor who bought the stock at the high of $1.60 is already down by almost 45 percent.

This is the type of swing that happens in stocks which do not have much trading going on; in other words, very little buying or selling pressure will make the price swing up or down significantly. A more general analysis of the characteristics of volatility can be seen in this review of the most volatile stocks for day trading, which explains what tends to drive these swings.

Step 3: Screen for Pump-and-Dump Red Flags

The basis of the pump-and-dump scheme is to create buying interest in a stock that is already owned by insiders who will later sell the stock into their own created demand. If the pump-and-dump indicators below are looked out for before buying, the pattern will be easily identifiable:

• An abrupt and inexplicable rise in the volume and price levels without any news from the company itself.

• Promotion through unsolicited emails, postings in social media sites, and newsletters which have promises of achieving a certain target price.

• An ill-defined or constantly evolving business model, even trying out a popular industry without a proven track record.

• High levels of insider sales when promotion takes place. This can be traced in regulatory reports.

• Lack of audited financial reports or a very long time since the previous report.

Step 4: Verify the Company Actually Files With the SEC

Firms registered with the SEC must make periodic filings, including their 10-K annual report and their 10-Q quarterly report, all available from the SEC's free EDGAR database. Stocks that have been filing for years or none at all have far less evidence to show for themselves than those that are filing at present.

Not all the companies filing with the SEC are necessarily legitimate. There are those trading on the over-the-counter market at lower levels, with lower filing requirements. While this in itself does not indicate a problem, it means there is less information independently verifiable, which makes every other item on the list critical.

Step 5: Research the Company and Its Officers

Apart from all this, one might discover a trend through a brief investigation of the company’s executives that is not obvious to the naked eye when just looking at the stock prices. Searching for the name of the CEO or founder together with the keywords SEC enforcement, trading halt, or bankruptcy could do the trick.

But even the actual operations of the company should be taken at face value. Whereas a business whose operation could apply to just about anyone, or whose business plans have been revised frequently in a short amount of time, should warrant more scrutiny than a business with a distinct and consistent track record.

Step 6: Size Your Position Before You Buy

This means that the position size must be decided prior to making the trade (not adjusted after the price move) because penny stocks may make sudden moves in one trading session. A typical way of deciding the position size is to risk 1% to 2% of the total account equity, and the number is calculated according to the distance to an exit point predetermined, not randomly picked up.

The calculations that are used for size estimation in more liquid stocks use the exact same mathematical model, except they use a larger slippage buffer. This guide on a risk management position sizing calculator explains the formula in greater depth and can easily be adapted to a penny stock portfolio..

A Practical Pre-Trade Checklist

Prior to ordering a trade, the steps outlined above may be abbreviated as follows:

1. The average daily volume has been taken up against the proposed position size.

2. The price fluctuations have been viewed beyond that of the current price.

3. Pump and dump symptoms have been considered for the stock.

4. The SEC filing (with the availability/absence) have been considered against EDGAR search.

5. The officers (and its business) of the company concerned have been analyzed.

6. The trade size against a predefined stop loss has been calculated.

When Penny Stocks Might Fit Your Portfolio

Penny stocks, nevertheless, should not be ruled out from being a good investment opportunity for everyone. The person who has done his homework and has analyzed whether the stock is liquid enough, or what possible risks he might be taking by investing in it, stands in a very different position than someone else doing this on hearsay only.

Getting Started With a Small Position

The use of this method does not require significant capital to get started. Even a tiny test investment, which falls well within the range of 1-2 percent mentioned above, is sufficient to conduct the whole analysis process without posing any danger to the other investments.

Before Looking at Alternatives

But not all investors are comfortable with the additional risks associated with the individual trading of penny stocks, even after considering the factors mentioned above. In view of the above, it will be interesting to examine how the direct approach fares with respect to some other low-risk approaches to the same exposure, like diversifying through funds or ETFs.

Safer Alternatives for Low-Cost Entry: Fractional Shares and ETFs

By means of fractional shares, the investors get the opportunity to invest smaller dollars in a stock that is highly liquid but costs a lot of money, rather than opting for a whole share in an illiquid and low-cost stock. A more detailed look into the treatment of these fractions, especially dividends, can be found in this brief overview of fractional shares.

An ETF on small-cap or large market stocks is similar to penny stocks in that it provides an inexpensive way of investing in the markets; however, it will be more diversified than the penny stock, which means less risk overall.

A Quick Comparison of Direct and Indirect Exposure

Investing in penny stocks directly means having all the associated pump-and-dump and high volatility risks, with exposure to only one company, and with no liquidity, as mentioned earlier in this paper. Investing in fractions and ETFs is the trading of concentrated gains for significantly lower risks of manipulation and low liquidity, and works well for someone looking for exposure to the stock market.

Applying This Framework With Pocket Option's Demo Account

One should follow the steps mentioned above prior to investing any funds in trading. Liquidity assessment, volatility testing, and red flags screening are carried out separately. Repetitive usage of such a procedure helps form a habit of conducting all the tests each time without omitting certain of them just because one likes a particular stock. In case when an appropriate instrument is available on a demo account, one can practice how to conduct a trade with it and not verify the research done before because Pocket Option’s OTC mode does not represent real OTC penny stock trading and therefore no particular penny stock is expected to be available.

This is just like the same discipline that is applied in position sizing and stop losses. Since demo mode involves no risks at all, it helps develop the discipline of executing trades on stocks having volatile price swings - although it does not substitute the research made in Steps 1 to 6.

Final Thoughts Before Your Next Trade

All of the above six stages are not difficult on an individual basis. The difference between being structured about it and running after a tip is completing all of the above at every stage without missing out any, regardless of whether the stock is already in motion or not.

Conclusion

Liquidity, volatility, and risk of being pumped up and dumped are not three individual warnings to keep in mind as secondary thoughts. Rather, they are a series of tests that could be done to any penny stock within minutes. Those still interested in direct investment after conducting that test series will approach penny stocks as a process, and not as a rumor; and those, who think the danger outweighs the allure, have the alternative of fractional shares and ETFs as a lower-risk way to stay exposed to the same broader stock market. Moreover, this strategy can be used by investors in order to differentiate actual investments from short-term speculations which are motivated only by the hype surrounding the stock market. Spending a little more time on analyzing these considerations will help to determine whether the reward is worth the risk.

Disclaimer: Trading carries great risks of loss of capital and might not be appropriate for all traders. Penny stocks, especially, are very risky due to high likelihood of illiquidity, volatility and market manipulation. None of the content in this article is financial advice, and the performance of any stock in the past does not indicate the likely future performance.