Trading low-priced stocks in 2021 seemed like an easy task after GameStop’s meteoritic surge. Anyone who got in early enough on the trading action could have been rewarded with a life-changing return.
GameStop wasn’t alone as other penny stocks joined in on the action, such as movie theater chain AMC Entertainment.
While these recent surges may have been exciting for many, the reality is trading penny stocks (and stocks in general) is not meant to be this easy. The vast majority of traders lose money, but understanding the most common mistakes can help a new trader’s chance of success.
Here is a list of 7 mistakes penny stock traders make that lose them money.
But first, what is a penny stock?
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What is a Penny Stock?
Generally, a penny stock is a share of a public company that is traded for less than a dollar per share.
On the other hand, the U.S. Securities and Exchange Commission (SEC) terms penny stocks as shares that can be traded for less than $5 a share.
The name was coined before the reclassification by the SEC when many shares were able to be traded for “pennies on the dollar.”
No matter which definition you use, penny stocks are those that can be traded for little money per share and are attractive to investors for that reason. In fact, many penny stocks can be bought in large quantities while spending relatively little money.
Because penny stocks are inexpensive, they are often more volatile and thus more risky as an investment. The penny stock market’s volatile nature also makes it easier to manipulate the stock, such as with the recent GameStop craze.
While easy to invest in and trade, it is important to utilize the same investing strategies you would with any other stock when investing in penny stocks. Diversification in your portfolio is key so that you aren’t over-reliant on a few companies, as well as an asset allocation that reflects your risk tolerance and investing goals. It is also prudent to do your due diligence in researching the company before investing a large sum into a stock.
Unfortunately, many investors jump in when a stock gets hot or because it’s cheap and may get themselves into trouble. Here are 7 mistakes penny stock traders make that tend to lose them money.
7 Mistakes Penny Stock Traders Make That Lose Them Money
1. Assuming a GameStop Surge Will Happen Again
GameStop’s surge will likely prove to be a once-in-a-lifetime occurrence as it was brought on by a perfect storm of events. First, GameStop’s short interest rose above 100% and even experienced and veteran traders weren’t aware this was possible.
Second, while many hedge funds were shorting the stock expecting it to ultimately go to zero, the video game retailer presented to investors a commitment to turning itself around, focusing on digital sales.
Third, GameStop’s stock was heavily mentioned on Reddit forums, and a surge of new retail investors flooded the market to buy the stock at seemingly any price. This forced the large hedge funds to start covering their positions (i.e., buying the stock), which merely added fuel to the fire.
New penny stock traders thinking they found the next GameStop and betting big on a surge will almost certainly lead to large losses.
2. Penny Stocks are Risky by Default
Penny stocks are cheap for one of two main reasons.
First, shares of a company trade at such a low price because investor demand for the stock or consumer appetite for their products are extremely low, maybe even nonexistent. Many new traders think they have found a hidden gem hiding in plain sight, and the stock is ready to explode — but with very few exceptions, this is rarely the case.
Second, fraud in penny stocks is rampant — and this is no hidden secret. Scammers are banking on inexperienced penny stock traders to fall victim to common pump and dump schemes. Scammers will lie about a penny stock’s outlook in hopes of getting new investors to bid the stock higher so they can sell their shares at inflated prices.
3. Not Having a Trading Plan
Buying and selling penny stocks is fairly cheap, so new traders enter the industry unprepared and without a proper strategy. Trading penny stocks requires many different skill sets, including understanding advanced technical analysis techniques, knowing how to filter stocks, and identifying the right trading setups, among others.
Instead, many new penny stock traders transfer $500 to their brokerage account and buy 1,000 shares of a 50 cent stock and hope it magically rises to $1.
4. Lack of Confidence
New penny stock traders who fully understand the risks involved in trading penny stocks often lack the necessary confidence to trade. This isn’t necessarily a bad thing, but it is a mistake. After all, it does seem like a scary task to enter a profession where losing money is the norm.
But this is the nature of trading penny stocks.
As a general rule, new penny stock traders should always commit to making “better mistakes” as each day passes while fully understanding they will lose money along their penny stock trading journey.
The confidence level will naturally increase as traders lose less money on more trades and a path to profitability is within reach.
5. Having the Wrong Mentality
Expert penny stock traders attribute a major part of their success to having the right mindset. Trading will at times become stressful, and there will be days where it seems nothing is going right.
The ability to take a loss on a trade gone bad is a lot more difficult than it seems. New traders will often think they are, in fact, on the right side of a trade, and a turnaround in fortunes is minutes away.
But expert penny stock traders have the mental capacity to act otherwise by taking a loss and moving on without hesitation. Moments like these are the difference between success and failure.
6. Getting Trapped in the Hype: Part 1
YouTube is home to hundreds, if not thousands, of educational videos that make it seem as if it is easy to make a living trading penny stocks. Many educators explain their proprietary “full-proof trading strategy” on how easy it is to trade.
It might sound convincing to new traders, especially those convinced that high-end and professionally produced videos are sufficient confirmation of an educators’ knowledge of trading stocks.
This isn’t to say that new penny stock traders can’t find excellent quality online. The opposite is true, but it is important to look for someone that is honest and acknowledges penny stock trading is risky, and most new traders will fail.
7. Getting Trapped in the Hype: Part 2
YouTube isn’t the only home to deceptive practices meant to convince penny stock traders they have an easy path towards success. New-age brokerage platforms are just as guilty of minimizing potential risks associated with penny stock trading.
Most notably, Robinhood has been accused of convincing its users and the public that trading is easy and fun. The “gamification” of trading is a powerful psychological tool specifically designed to attract new penny stock traders and convince them that trading is much less risky than it really is.
Massachusetts regulators filed a suit against Robinhood and argued:
“Treating [trading] like a game and luring young and inexperienced customers to make more and more trades is not only unethical, but also falls far short of the standards we require in Massachusetts.”
Moral of the Story
Penny stocks are an accessible way for many would-be investors to get into the market without spending a ton of money upfront. The downside to accessibility is that penny stocks also tend to be volatile, and investors can be drawn into penny stock scams.
While we aren’t suggesting you completely avoid penny stocks, we encourage you to practice sound investing principles and avoid getting caught up in the emotional frenzy often created by these stocks.
Even experienced penny stock traders lose money, and beginning traders are almost certain to lose money. We’ve detailed the 7 main mistakes penny stock traders make and why they may lose money in this post, as well as ways to mitigate those losses.
As the saying goes, make sure you don’t put all your pennies in one stock.
Talk about Money Learned.