Trading in penny stocks can be an incredibly risky venture. Despite wildly successful tales from investors who’ve claimed to earn triple-digit returns on penny stocks, the reality is most penny stocks will likely go to zero.
One of the most famous penny stocks in Canada is Bre-X Minerals, the Calgary-based exploration company whose stock soared from 30 cents per share to more than $250 before being exposed as a fraud in 1997.
Still, for some investors, the allure of turning a small penny stock investment into a 10-bagger is too tempting to pass up. If you’re one of those investors, this article will explain everything you need to know about penny stocks, including why and how to invest in penny stocks in Canada.
What Are Penny Stocks?
A stock doesn’t necessarily need to trade for under $1 to be considered a penny stock. Technically, penny stocks are defined as micro-cap stocks, meaning a stock with a market capitalization between $50 and $300 million. If the company is valued at less than $50 million, it’s considered a nano-cap stock.
Compare this to the largest 10 stocks trading in Canada (think banks, telecommunications, and pipelines), which have a market capitalization of between $35 billion and $100 billion. You can see why trading smaller stocks can be riskier than investing in large blue-chip companies.
The Securities & Exchange Commission (SEC) defines penny stocks as any stock trading for less than $5. Another definition is that any stock trading over-the-counter (OTC) or on pink sheets should be considered a penny stock.
Typical Penny Stock Traits
The majority of penny stocks in Canada fall into these categories and sectors:
- Oil & Gas
- Mining (i.e., Gold, Silver)
All are highly speculative industries, so these penny stocks are extremely sensitive to macro factors such as commodity price movements, industry news (both good or bad), or regulatory changes.
Think of it this way: A penny stock trading for 50 cents per share sees its share price fall by 10 cents on negative industry news. A seemingly benign 10-cent move is equal to a 20% loss on your investment!
Penny stocks are extremely risky and typically represent companies at opposite ends of the spectrum: from companies in their incubation phase with nothing more than an idea and some venture capital behind them looking to break out to established debt-laden companies on the verge of bankruptcy. Other penny stocks might be outright scams (see Bre-X).
Why Are Penny Stocks So Risky?
Penny stocks make risky investments for several reasons:
- Transparency / Lack of Public Information - Companies listed on the pink sheets or over-the-counter are not required to file with the Securities & Exchange Commission like larger stocks traded on an exchange. That makes it difficult to find tangible information on penny stocks.
- No Minimum Standards - Sometimes, the only reason why a stock is not traded on a major exchange is that it failed to meet the minimum standards to be listed. These standards include annual listing fees and timely filing of financials.
- Lack of History - Whether the company is newly formed or approaching bankruptcy, many penny stocks generally have poor track records or none at all.
- Low Liquidity - Stocks trading OTC or on the pink sheets have low liquidity, meaning investors cannot easily buy or sell shares without finding a willing buyer or seller. Low liquidity also leads to price manipulation and the threat of scams.
Penny Stock Scams
The classic penny stock scam is known as the pump and dump. Famously portrayed in movies such as “Boiler Room” and “The Wolf of Wall Street”, pump and dump scams occur when an investor buys large amounts of stock, hypes it up to unsuspecting retail investors, and then sells it once investors have sufficiently bid up the price.
Another scam to watch for includes biased (or paid) recommendations from newsletters and social media that persuades investors to purchase a particular penny stock that’s poised to skyrocket.
Why Trade Penny Stocks?
If you decide to trade penny stocks, you need to do so with your eyes wide open. Despite the risks, some investors are drawn to penny stocks for the chance to earn big profits with just a small investment. Who doesn’t love a good investing success story?
Let’s say you bought 2000 shares of a penny stock trading at 46 cents per share. That’s a $920 investment (maybe a ‘bet’ is more accurate) in that penny stock. If that stock happens to reach $1, then you’ll have more than doubled your initial investment.
To get that elusive 10-bagger (10x its purchase price), the stock would need to reach $4.60. If that happened, then your initial $920 investment would now be worth $9,200.
Still, the more likely scenario is the share price stays under $1 and possibly goes to zero if the company fails.
The extreme risk and volatility of penny stocks mean investors need to do their homework before investing. Rather than trying to hopelessly pick one winner, a better strategy might be to take the venture capitalist approach and divide your investment among five to 10 penny stocks – diversifying your risk and increasing the chances of finding the elusive winner.
Be extremely wary of any online newsletter promoting the best penny stocks to buy in Canada. As mentioned above, there’s no way to tell if the information is biased and/or part of a scam to promote a particular stock to benefit someone who already has a position and is waiting for you to buy so they can unload.
Finally, don’t invest more than you’re willing to lose. Investing in penny stocks is akin to gambling and should only be done outside your core TFSA and RRSP holdings and never with money, you’re counting on to fund your retirement.
How To Invest in Penny Stocks
As mentioned, penny stocks can only be purchased OTC or on the pink sheets. So how does the average retail investor purchase penny stocks to trade in their own portfolio?
To buy penny stocks in Canada, you’ll need to go through a broker, and the best way to do that is through an online discount brokerage. Our favourite online discount brokerage is Questrade, where you can get $50 in free trades when you open a new self-directed invested account.
Questrade provides traders with access to the Over The Counter Bulletin Board (OTCBB) to allow them to trade smaller cap and more thinly traded stocks that are regarded as high risk (i.e., penny stocks).
Investors can trade penny stocks at other discount brokerages besides Questrade, so you might want to review our ultimate guide to Canada’s discount brokerages to find a brokerage that best suits your needs. You can also check out our full Questrade review for all the reasons why we love this online trading platform.
Where To Find Out More About Which Penny Stocks to Invest?
I write this with great hesitation, as information on penny stocks can be extremely unreliable. In addition, news travels fast and so take any stock-specific or industry recommendation with a huge grain of salt because that information is or should already be priced into the market.
Here are two sources for penny stock information that seem reputable:
SmallCapPower: “The industry’s leading and most trusted source for small-cap stock coverage, research, and analysis.” SmallCapPower covers a wide range of penny stocks in industries such as gold, base metals, energy, technology, sustainability, marijuana, battery metals, and blockchain. One of its columnists is Canadian author and active trader Robin Speziale.
The site is loaded with all of the latest news and insights of small-cap companies. Check out their top 10 Canadian marijuana stock picks as an idea of where to start investing in the cannabis sector.
AllPennyStocks.com: This is another good source of information to use as a starting point for investing in penny stocks. This site features more detailed analysis and charts for investors to sort through, including penny stocks to watch – a feature that uses technical analysis to identify hot penny stocks.
Remember, these sources are just starting points to give you an idea of penny stocks in which to invest. Do your own research to determine whether it’s a worthwhile investment, and make sure you understand the risks before putting your real money on the line.
We’ve all heard of successful penny stock stories, and wouldn’t it be nice if we had our own tale of earning triple-digit returns on a penny stock investment?
The fact is, penny stocks are some of the riskiest investments out there, and investors need to be cautious. Know that you’re trading on what little public information is available, and what is available may be unreliable.
Be prepared to lose money, maybe even all of it, if the company goes bankrupt or turns out to be a scam. Penny stocks should only make up a tiny fraction of your portfolio and never be counted on for your retirement savings plan.
Investing in penny stocks is like taking a big swing for the fences in baseball. You may hit a home run, but more than likely, you’ll strike out. With that mindset and eyes wide open, you can try your luck at penny stocks and hopefully find that diamond in the rough.