The allure of penny stocks is simple - quick riches.
I am sure you are familiar with Jordan Belfort who has been etched in Hollywood history in the movie, The Wolf of Wall Street. Let’s fast forward to a scene in the movie where Jordan is training his eager-to-defraud crew of brokers in his 1989 founded boiler room, Stratton Oakmont:
“First we pitch them Disney, AT&T (NYSE:T), IBM (NYSE:IBM), blue-chip stocks exclusively, companies these people know. Once we sucker them in, we unload the dogshit, the pink sheets, the penny stocks, where we make the money, 50% commission baby!”
The plan was simple and ingenious, pitch a hyped picture of the huge upside potential of totally worthless pink sheets or penny stocks to the richest 1% of the US, milk as much “investment” out of them as possible and bank half in commission.
In 1999, 10 years after first founding Stratton Oakmont, Jordan Belfort was sentenced to 4 years for defrauding investors out of almost $200 million, a classic “pump and dump” scam.
Traders You Should Really Know
Say The Wolf of Wall Street to anyone and the responses of how funny and inspirational the movie is are instantaneous with little regard for the people Belfort defrauded.
Now ask people if they have heard of The Turtle Traders, a true account of novices that were taught to trend trade and made almost $200 million, and the look of bemusement is unsurprising.
I have been trading since 2007 and the number of investors and traders I have met who are still unfamiliar with The Turtle Trader experiment is high. If they are familiar with it, The Turtle’s approach, a proven long-term system, is regularly dismissed for the array of modern-day get-rich-quick schemes.
The consequences are massive as it puts a huge dent and delay in people achieving their financial and lifestyle goals.
The Turtle Experiment
In short, this is how The Turtle Trader experiment went. Richard Dennis believed anyone could be a trader if they were taught to follow a proven system. William Eckhardt said nonsense, you are born a trader, the classic argument of nurture vs nature. So in 1982, the close friends put an advert in the Wall Street Journal inviting people to an experiment where Richard Dennis would teach them how to trade.
Out of 1000 that applied, 21 novices were selected after a rigorous selection process. Richard Dennis taught them his system in 2 weeks and over the next 4 years, they turned over $186 million. There is more to this fascinating story which you can read in Way of The Turtle by Curtis Faith or listen to interviews on YouTube with several of The Turtles.
The Turtle System
The question I hear you ask though is “What system were they taught?”
The answer - Trend Trading - using a breakout strategy that profits very very handsomely from sustained moves in the markets that last for weeks, months, even longer. It is a timeless method that has been used for decades by the greatest traders, traders such as Jesse Livermore, Nicholas Darvas, Jim Rogers, John W. Henry, et al.
Are You Asking Yourself The Right Questions?
Fast forward to today and it seems that not much has changed with the allure of quick-riches through penny stocks and the various forms of day trading as strong as ever.
What traders, particularly newbie traders, have to ask themselves is what is the quickest AND safest way to make as much money as possible with the (often limited) funds AND time they have? And if some forms carry a far greater risk of losing money than making money, are they worth pursuing?
Both trading and investing are about making smart choices to make your hard-earned money work hard for you. The best techniques are often simple to implement but it is the patience required to extract profit that is not easy and is the biggest challenge.
Let’s Talk Lifestyle
Most who venture into the world of investing and trading are in some form of 9 to 5 or are business owners and have a life outside of work so time is indeed short. This is most likely you. You have worked hard to earn and save that pot of money that you want to invest with. Is taking a risk on a penny stock where the very real possibility of losing 50% to 100% of your investment the smartest choice? It isn’t.
Very few penny stocks actually work out. You may get lucky on your first punt and find that one unicorn that shoots to the stars but the chances of that happening are slim to none. The reality is that you are likely to lose all of your money on penny stocks that have been promised to deliver but just lead to one heartbreaking loss after another.
Trend trading is a far better start to your trading career both in terms of lifestyle benefits and execution of trades, the execution benefits I go into more detail below.
In terms of lifestyle benefits, trend trading is unbeatable and here is the main reason why:
It’s adaptable around the busiest of lifestyles with minimal fuss!
My routine starts with good weekend preparation where I use scanners to scan 1000s of instruments in minutes and then use my bespoke trading tools to manually go through the results of the scans to find the very best setups across forex. UK stocks, US stocks, commodities and cryptocurrencies. This often takes no more than an hour, maybe 2 at max. With the weekend preparation done and a short-list of the best instruments created, Monday to Friday takes no more than minutes a day entering new trades and managing open trades.
Trend trading and this routine have allowed me to generate very healthy returns in the last bull run in stocks in 2017 which you can read more about in our blog on how to buy stocks in 5 simple steps.
You can see how this fits around the busiest of lifestyles without compromising on time or profit. For those living in the UK, trading using spread betting accounts comes with tax-free benefits.
And here is the real beauty of trend trading:
Once you have built an account that funds a lifestyle and you are in a position to quit the 9 to 5, the routine of weekend preparation and minutes a day Monday to Friday entering and managing trades does not change. This is when you are in complete control of you both your money AND your time.
Trading penny stocks will never give you this. Let’s discuss why...
A Definition Of A Penny Stock
First, here is how Investopedia defines penny stocks:
In the past, penny stocks were considered any stocks that traded for less than one dollar per share. The U.S. Securities and Exchange Commission (SEC) has modified the definition to include all shares trading below five dollars.
Because of the low liquidity, investors might have difficulty finding a price that accurately reflects the market.
Due to their lack of liquidity, wide bid-ask spreads or price quotes, and small company sizes, penny stocks are generally considered highly speculative. In other words, investors could lose a sizable amount or all of their investment.
In other words, investors could lose a sizable amount or all of their investment.
Just highlighting the last point!
Do You Really Know What You Are Getting Into?
So, the chances are you only really know part of the story and are focusing more on the money that can be made rather than paying more attention to the pitfalls and what you have to lose. Good trading is always about protecting your downside first and using your hard-earned money as a foundation to build wealth.
Under no circumstances, do you want to give it away cheaply either to the markers with poor trading decisions or scammers dressed as traders promising unrealistic goals.
And so here are 8 reasons why trend trading proven stocks on the FTSE and NYSE compared to investing or trading penny stocks is a far safer and more rewarding approach for you, the private trader:
1. Better regulations
First and foremost, even though I have just said it above, it is good to be reminded again, you have put days, weeks, months even years into saving that pot of money you are ready to invest so under no circumstances do you want to give it away cheaply.
As penny stocks are loosely regulated, you leave yourself open to a whole manner of scams and scammers from pump-and-dump to short-and-distort to guru scams and more. It’s uber difficult to find credible information on whether a penny stock is likely to die or survive, let alone thrive and this gives plenty of leeway for scammers to deceive and hype and lure the vulnerable into investing into dud stocks and doing a runner with your hard-earned money.
Just because there is no grey area, go ahead and remind yourself of the quote above from The Wolf of Wall Street. This will not happen with proven stocks listed on the FTSE or the NYSE traded through a reputable broker which have regulations in place to protect you for a certain amount often around £80,000 here in The UK. THAT MEANS YOUR FIRST £80,000 IS PROTECTED WHICH YOU DO NOT GET WITH PENNY STOCKS. I mean, if there is a single reason to trade proven stocks over penny stocks then this is it. You have a solid foundation in place to use your PROTECTED hard-earned money to generate long-term wealth without some shyster running off with it.
2. A proven history of trends
Good trading and investing are not stressful. It’s a process of finding the best instruments, whether it be stocks, forex or commodities, that have good upside or downside potential and that move with “linearity”. You see, price can have a long-term bullish or bearish direction to it, known as a trend, but does not move in a straight line. There is a natural movement to price made up of breakouts and pullbacks that must be expected and embraced to see a good return on your risk.
Linearity to price is where these breakouts and pullbacks are clean and almost uniform. This is where technical analysis comes in and looking at the history of the chart to see what kind of behaviour a particular instrument has displayed in the past as this is very likely to repeat in the future.
There are 1000s of stocks on the NYSE that have a much better history of linear trends compared to penny stocks, many of which are unproven and short-lived history. If they do have a history, they are likely to show a lack of trends and so moves to the upside and downside are volatile and short-lived. The odds are very much in your favour to see a return on your risk on good trending stocks which display volatility in a direction but also the journey from entry to exit will be far more pleasant. Life already has enough stresses and challenges to it, why add to it with a portfolio made up of uber erratic penny stocks that are only likely to end in disaster?
3. Better liquidity
Both entering and exiting from an instrument has to be instantaneous and you want your broker to honour the exact price or as close to the exit price that you want. With proven stocks, you have the option to filter for stocks with high volume so being saddled with a stock you do not want is not an issue.
When your exit plan has been met, whether it be from going long or short, removing the stock from your portfolio is instantaneous and hassle-free. This is not the case with penny stocks as they tend to be thinly traded making it a far bigger challenge to place a buy or sell order on the stock.
A lack of liquidity on a stock means facing the very real risk of paying a higher price than you want or selling it for much less than you want and in the worst-case scenario, not being able to get rid of the stock as there are simply no buyers to offload them to once you have purchased them. Why have your money tied up in a penny stock where you are likely to not get the buy and the sell price or not even be able to sell at all if it is poorly performing, which it has every chance of doing?
4. Better spreads and so lower costs
Due to better liquidity, the spreads on proven stocks are far cheaper drastically reducing your broker costs. The spread is the difference between the highest price a trader will pay for a stock and the lowest price a trader will sell it for and is what the broker pockets as their cost of doing business with you. Proven stocks will have a much smaller spread compared to penny stock as there are far more buyers and sellers involved, not only making it easier to enter and exit a stock but also making it far cheaper. With the lack of volume of buyers and sellers involved in penny stocks, not only are the spreads far wider making the cost of doing business far more expensive but there is also no guarantee of entering and exiting at the price that you want. And don’t forget, there is also the very real risk of not being able to get rid of your poorly performing penny stock at all if there is no one to sell them to.
5. Less margin required
For those using broker accounts that offer margin, proven stocks will require far less margin per stock meaning the ability to create a more diverse portfolio and to manage and spread your risk far better across a number of proven liquid stocks. This will then allow you to easily cut out of losing trades, hold onto and add more winning trades as well as add new good looking stocks to the portfolio. This really is key to making consistent growth on your account. In comparison, the margin on penny stocks can be as high as 50% meaning a very tiny portfolio of badly performing stocks that potentially you may not even be able to get rid of if you have no one to sell them to. I hope the penny is dropping here, no pun intended!
6. Gapping is manageable
Gapping is part and parcel of trading all forms of stocks and is part of the added risk of trading stocks. However, on proven stocks gapping is far less of a hindrance due to high liquidity. Gaps that happen against the trend are often small and well handled by a well-placed stop-loss. They are easily filled and price may simply correct and move back in the direction of the established trend. Gaps that happen in the direction of the trend often inject momentum into the trend which means profit and entry points.
Now gapping can cause price to go through a stop-loss which means a greater loss than planned but with a good risk management system, this additional loss is often small and easily recoverable. Being aware of events such as mergers and acquisitions ahead of time will give you the opportunity to cut out of stocks in advance so as not to get caught up in overextended gaps such as that on Fox in early 2019 when it was acquired by Disney.
Dealing with gapping is not the same when trading volatile penny stocks. Due to low liquidity, large gaps are a far bigger threat as the nearest asking price may be some distance away meaning much larger losses. It makes a lot more sense to be dealing with stocks that gap small against you or that add momentum into the trend when price gaps in your favour, right? Rather than being swung from left to right with large and unmanageable gaps on penny stocks?
7. Compounding
In my opinion, if there is no opportunity to compound then why bother? Compounding is where you add more of a winning instrument to your portfolio and is the key to exponentially growing an account. Let’s take Mr Warren Buffett who has made 99% of his wealth after he turned 50. Before 50, Mr Buffett was worth around $300 million. Today, Mr Buffett is worth around $80 billion. That is a staggering growth which can only be made from compounding.
Now, you may never get to a point or may not even be interested in dealing with those kinds of numbers but don’t make the mistake of underestimating what your money is capable of. You certainly want to get the most out of what your hard-earned money can do for you and that can only be done by compounding and that is why you want to be trading or investing in proven stocks.
Once you have a stock, or even a currency pair or commodity, that has a history of performing well, that is liquid and is currently showing strong signs of linearity (as mentioned in point 1), then you want to strategically and repeatedly add more of that instrument as opposed to diversifying your portfolio. Compounding allows you to have an initial small risk but a far larger return as you hold and add more of that instrument to your portfolio particularly as instruments can trend for months even longer. This is in line with the very foundation of good trading and investing which is to let your winners run and cut your losers short as well as understanding that the trend is your friend until the bend at the end.
Penny stocks will never give you the opportunity to compound as they simply do not trend long enough to allow you to do so and which is why they require a much larger initial risk to make a worthwhile return and due to their erratic behaviour, why the potential of losing that money is far greater. All in all, penny stocks offer very little in terms of a safe haven for your money both in terms of risk and reward. Don’t let the hype around penny stocks sucker you in. Proven stocks are where you want to be.
8. You are nowhere near 0!
It’s probably obvious to most but I guess something that is overlooked when it comes to penny stocks is how they are just a skip and a hop away from bankruptcy. What is so appealing investing in a stock that is so close to 0? Personally, I wouldn’t go anywhere near a stock that is so close to going bust and instead, look for stocks that are trading above at least £5 on the FTSE and $20 on the NYSE.
As already mentioned, good trading is about protecting your downside first and letting the money effortlessly come to you which is quite simple to achieve with proven stocks. With penny stocks, the mindset is upside down and back to front with the emphasis on quick returns but the threat of losing it all with the stock dropping to 0 at a blink of an eye is something you have to realise can and will happen. Why put yourself through that, losing your hard-earned money you have spent months saving only to give it away in a much much shorter time? Time is everything as you know. Each time you lose money means having to work more and save more money or starting from a large deficit which means taking longer to recover from losses which means taking longer to see growth and for the compound growth effect to kick in which means a longer delay on achieving your goals which means longer in the 9 to 5 if you are looking at trading as a way out! Phew! I hope you’re really getting this, proven stocks good, penny stocks bad!
Is There Any Place For Penny Stocks?
Personally, I wouldn’t touch them with a barge pole. There is simply no appeal to them apart from the over-inflated promises of quick riches. Proven stocks have never let me down and will never let me down. Throw in forex, commodities and even the cryptocurrency markets and I have plenty of options available to me to look for low-risk setups that can and will deliver compounded growth.
If you still feel that penny stocks are worth the very real risk of losing your hard-earned money and are confident that you may have discovered an almost impossible-to-find penny stock that is being run as a profitable business, that has the potential to grow into a mid-cap or large-cap stock and which will handsomely reward early investors, then be smart with your risk.
“Never test the depth of a river with both feet” as Warren Buffett said.
It is imperative to do your due diligence so as to avoid being scammed. Look at the books of the company and watch corporate presentations and if you are convinced you have found a penny stock unicorn, then invest a small percentage of your pot and accept that what you put in you are more likely to lose than profit from.
If you ask me, it just sounds like a hell of a lot of work for a stock that is likely to fail.
It is far easier, safer and the odds are very much stacked in your favour to make consistent long-term profit by applying technical analysis and a proven trend trading strategy to proven stocks, forex pairs, commodities and even cryptocurrencies.
Keep it Sublime!
Zaheer Anwari