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.