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When you’re just starting out investing on Robinhood, it’s tempting to go with low-priced stocks. You might be on a low budget and only have a few bucks of play money to throw into your account every month. Buying penny stocks also comes with thrill of finding a diamond in the rough; what investor doesn’t want to buy a stock for under $1 and then see it skyrocket to $50 or more? However, before you pull the trigger on a Wall Street bargain bin special, you should know the facts about buying penny stocks on Robinhood, and the myriad risks this can involve.
What is a Penny Stock?
First things first: let’s define what a penny stock is, so we are on the same page. According to Investopedia:
A penny stock refers to a small company’s stock that typically trades for less than $5 per share. Although some penny stocks trade on large exchanges such as the New York Stock Exchange (NYSE), most penny stocks trade via over the counter (OTC) transactions.
So a penny stock is not just a stock that trades literally for pennies, nor are they all necessarily stocks that you’ve never heard of. Using the definition above, some notable penny stock names include JCPenny (JCP), Eastman Kodak (KODK) and Nokia Corporation (NOK). What do you notice about these stocks? That’s right, they are fallen giants of yesteryear. The vast majority of stocks under $5 are there because they are in trouble. That makes investing in penny stocks a risky and volatile enterprise. But it’s not all bad.
Penny Stock Benefits
While penny stocks have many risks, there are some potential upsides to investing in them.
- Penny stocks are generally less researched and followed compared to major companies like those in the S&P 500. Think you are going to find something undiscovered about Apple that the 44 Wall Street analysts who cover it will not? Fat chance. But there are tons of under-covered names in the penny stock world, providing those willing to do the work an advantage.
- Some penny stocks get unfairly oversold. When a stock disappoints investors there can be a pile on effect driven by large institutional investors and high-frequency traders that pushes the stock into the graveyard, even if it still has a good bit of life left. Take Diebold (DBD), the largest manufacturer of ATM machines globally. After a series of horrific earnings misses and C-Suite turnover, the stock cratered from more than $37 to a low of $2.50 at the beginning of January 2019. Today it trades at $11.11, a more than 500% gain!
- Penny stocks will often move sharply on the slightest news, up and down. While this is a classic risk of penny stocks, it can also work to your advantage if you closely monitor the stock. One small announcement of a drug reaching a new level of FDA approval or a celebrity endorsement can send shares higher. This makes penny stocks a favorite of active traders because successful trading tends to rely on price volatility.
Penny Stock Risks
So penny stocks do have some pros! What’s the catch? They also have a long, long list of cons. Here are just the most prominent risks to keep in mind.
- Most penny stocks will go to zero. Remember the companies we listed above such as JCPenny and Eastman Kodak? Those are actually some of the higher quality penny stocks in this troubled universe. While JCP and KODK have their share of troubles, they at least have legitimate products and brand names that most people have heard of. When you dig deep on any given penny stock you’ll often find dubious or non-existent products and corporate leadership teams that wouldn’t look out of place on an episode of The Sopranos. Tim Sykes, the most well-known penny stock trader, said of the penny stock universe in an interview with Mint.com: “Ninety-nine percent of the civilized world hates penny stocks, because 99% of penny stocks are scams or are destined to fail.”
- Which brings us to our second point: because most penny stocks trade on less regulated over the counter (OTC) markets, also known as the Pink Sheets, these types of stocks are rampant with fraud, insider trading and other unsavory business and marketing practices.
- Penny stocks are extremely volatile. It’s not uncommon to see gains and losses in excess of 10% in a single day, and sometimes much more. Additionally, if you’re lucky enough to hold a stock with a big gain, those gains can evaporate and turn into big losses, often within the same day. This makes constant vigilance of your positions with a day trading broker essential if you’re going to dabble in these securities.
- Pump and dump schemes are rampant. Penny stock volatility is mostly driven by what is referred to as “pump and dump” schemes, where insiders typically bid up the price of their worthless company through dubious press releases, celebrity endorsements or other shady marketing tactics, only to sell once the prices has peaked, leaving the investors chasing the run up holding the bag as the stock craters.
- Penny stocks have terrible liquidity. Liquidity refers to how easy or difficult it is to buy or sell a stock on the open market. Due to all of the reasons discussed above, the average penny stock is not widely traded. A few penny stocks being “pumped” will gain interest, but it can be very difficult to sell for the price you see on your screen if everyone is trying to sell at the same time. This means the average investor also has to contend with “slippage” when buying and selling penny stocks, which refers to the loss between the price you want to sell for and the price you actually receive.
Still interested in finding penny stocks after reading about all of those risks? Here are some ways to buy penny stocks on Robinhood.
How to Buy Penny Stocks on Robinhood
The easiest way to find penny stocks on Robinhood is to use the app’s search functionality and type in “Most Popular Under $25.” This will pull up the Robinhood collection for the most popular low-priced stocks. While many of these stocks will not be penny stocks, at least 11 stocks under $5 were in this group at the time of writing. By sticking with “popular” penny stocks such as the ones in this collection, you are also less likely to have issues with liquidity, as mentioned above.
Of course, you are not limited to only the stocks in the above collection. If you want to go further afield you can use any popular stock screener such as Yahoo! Finance or Finviz.com. Set up your screens for stocks priced under $5 and then input the tickers you are interested in into your Robinhood app to see if the stock is available. You will have more luck finding stocks that are at least mid-cap or higher, as Robinhood will not have many of the smallest stocks that trade on OTC markets.
Reasons Not to Buy Penny Stocks on Robinhood
The reason buying penny stocks on Robinhood only works for the use cases above is because Robinhood is not an optimal solution for active day traders. Robinhood offers a great service for the average investor by eliminating commissions and other fees that used to be as high as up to $11 per trade only recently at other major brokers. In exchange, you are not necessarily given the priority with your buy and sell orders and may experience some degree of slippage when placing an order. This type of slippage is absolutely deadly to intraday traders, especially those focused on volatile penny stocks that can change direction on a dime (or a penny).
Robinhood was recently fined $1.25 million by regulatory body FINRA for failing to observe best practice price executions for its customers, further shedding light into issues with receiving the best price for customer buy and sell orders.
Recommended Brokers for Day trading Penny Stocks
If you want to actively trade penny stocks intraday and ride the pump and dumps to your heart’s content, we recommend taking a look at the following brokers for this purpose:
All three of these platforms are highly rated for active trading tools, order execution and the ability to access real-time market data.
A Better Option: Fractional Shares
Novice investors are often driven to penny stocks because of their low cost. Purchasing just a single share of Amazon will set you back $1,864 at the time of writing. That is out of reach for most individual investors and even if it is not, it makes it difficult to achieve a diversified portfolio.
The great news is that Robinhood recently announced they are offering fractional shares. Fractional shares are an excellent alternative for investors who want to access world class companies but can’t afford their often hefty per share prices. As Robinhood rolls this feature out, any user will be able to buy as little as $1 of household names such as Apple, Amazon, Facebook and Microsoft.
While some investors may still get a thrill from chasing penny stocks, the majority of Robinhood users would be better off “dumping” the idea in favor of fractional shares.
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