If you think you can make big money trading penny stocks, think again. These shares rarely have significant investment value

Penny stocks are often traded “over the counter” or on the “pink sheets” (a holdover term from when over-the-counter stock quotes were printed on pink paper), which means that they are often sporadically or inactively traded through “market makers.”

Market makers are responsible for maintaining an orderly market for a particular stock by standing ready to buy or sell shares and to maintain bid and ask prices for their assigned shares. This makes buying and trading penny stocks more difficult and more expensive than doing the same with inactively traded shares on larger stock exchanges.

Are Penny Stocks Worth It? Learn everything you need to know in 'Canada's Penny Stock Guide' for FREE from The Successful Investor. Canadian Penny Stock Guide: Find where to find Penny Stocks that pay well.  I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

Why investors might have to go to the “over-the-counter” market for trading penny stocks

The “over-the-counter” market (OTC) is a centralized information network that includes services designed to benefit market makers, issuers, brokers and OTC investors.

A company that trades over the counter is usually one that doesn’t meet the minimal criteria for capitalization and number of shareholders that are required by most stock exchanges.

Over-the-counter markets are generally of low quality and limited trading activity. These stocks rarely get much attention from analysts or investment publications and newspapers, which adds to the difficulty of attracting a buyer for your shares at a higher price.

We’d have to see an extraordinary opportunity to recommend anything in the over-the-counter market—and nothing we have yet seen comes close.

Understanding market cap while trading penny stocks

The market cap is the total number of shares outstanding multiplied by the current price per share. While many numbers and statistics frequently prove to be of limited value in judging stocks, there is one that is often underused: market cap. Market cap says a great deal about a company. A company’s market cap can grow even while its stock price falls, if it issues new shares. If a company’s market cap is close to or less than its total yearly sales, this may indicate that it offers substantial value.

A high market-cap-to-sales ratio makes a stock sharply vulnerable in a market setback. If its profit falls or if it fails to live up to investor expectations, its stock price can plummet. It’s best to avoid overloading your portfolio with stocks that have a high market-cap-to-sales ratio—and penny stocks most often fall into that category.

At TSI Network, we always look closely at a company’s market cap in our investment analyses. But beyond that, we also recommend using our three-part Successful Investor philosophy: Invest mainly in well-established companies; Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities); Downplay or avoid stocks in the broker/media limelight.

Low liquidity adds to the risk of trading penny stocks

Another drawback to penny stocks is that they generally have lower trading volumes or liquidity. A lack of liquidity means it may be more difficult to sell a stock when you want to. It’s also possible that you may be forced to sell it at a much lower price than you would like in order to attract a buyer.

Moreover, when a stock is a thin trader, it doesn’t take much buying or selling to influence its price. So if just one large investor decides to sell, it can cause an abrupt stock-price slump. This can spark a cascade of selling and a collapse in the stock’s price. The resulting stock downturn can scare off other potential investors. No matter how promising the penny stock is, this can make it impossible for the company to raise additional funds when it needs them. Less liquid stocks are also much more vulnerable to manipulation by unscrupulous traders or promoters.

Going online for trading penny stocks can lead investors into dangerous territory

You can make trades quickly in online trading, and that cuts your commission costs. However, for successful investors, this is a bonus, not the object of trading stocks.

The big risk with frequent online trading is that you’ll try out a risky and ultimately unwinnable investment approach, like day trading or options trading, and hit a lucky streak. This could embolden you to put serious money at risk just when your results are about to regress to the mean and deliver losses instead of profits. This is often the case with penny stocks.

All in all, it is far more important to follow the Successful Investor approach and focus on high-quality, well-established companies and how they fit into your portfolio. The longer you hold these stocks, the greater the chance that your profits will improve, as well.

Though penny stocks can be risky, they can on occasion be profitable. What kind of luck have you had with penny stocks that benefited your portfolio?