If you’re wondering whether or not Canadian penny stocks should have a place in your investment portfolio, you’ve come to the right place. Our guide to investing in penny stocks will not only teach you how to buy them, but will guide you through what exactly a penny stock is, scams you can avoid and helpful tips to getting started.
Investors looking to buy penny stocks are often drawn in by large returns. Because of the volatility of penny stocks, rapid price movements, often ones that would take a blue chip income stock a decade to earn can come in days.
There are a lot of investors who have hit the jackpot investing in penny stocks. But for every success story, there is probably 10 horror stories.
To experienced investors, Canadian penny stocks have a bad reputation
There is a time and place for penny stocks. For most seasoned investors, the time is never. But this isn’t because they are poor investment decisions, there is money to be made. It’s simply because the large majority of investors are not willing to invest their capital at such high risk. And by high risk, I mean substantially higher.
When I speak about the risks with penny stocks, I’m often comparing it to other investment strategies like purchasing stocks for value, purchasing them for their growth, or their dividend.
Before you continue reading, ask yourself how much you’re willing to lose. Gains with penny stocks can be accrued or wiped out in a matter of hours, and the large majority of investors simply can’t handle this risk.
If you can, lets continue and get started with what exactly a penny stock is.
What is the definition of a penny stock?
The definition of a penny stock is quite broad. You’ll get varying answers from different investors, but the general consensus is that a penny stock is a stock that trades below $5. However, it’s important to note that a lot of popular stocks, ones that don’t have the volatility or market capitalization of a penny stock trade below $5. So here is a few more guidelines to help you narrow down your search:
- Penny stocks are typically smaller companies, and their shares are often illiquid (not easy to buy and sell)
- They have a small following, and typically are not covered by major analysts
- They usually trade OTC (over-the-counter, more on this later) or through pink sheets.
You won’t find Canadian penny stocks trading on the TSX. This is often because they are too small to meet the requirements needed to list on major exchanges, and don’t file the proper paperwork needed.
Why are penny stocks more speculative than others?
Penny stocks are often inexperienced companies, trying to carve their name in an industry and outperform major competitors. With this often comes high debt levels and rapid expansion. As with most start ups, cash is not readily available, and one poor investment decision such as an acquisition or expansion could bankrupt a company.
Another reason is simply volume. Take for instance a company like TD Bank. With a market cap of over $130 billion, over 3 million shares trading on a daily basis and almost 1.85 billion total shares, it would be nearly impossible for one transaction to have a significant impact on the companies share price. With penny stocks, shares outstanding can often be below 50 million, and volume can be as little as 40-50 000 shares a day. A major owner of the stock could move a significant portion of their shares, resulting in drastic price movements. This is exactly why there are so many scams prevalent with penny stocks (which I will get to later.)
The majority of Canadian penny stocks are involved in oil and gas, mining, energy or technology. Typically these companies will have invested heavily in exploration efforts in the case of mining or oil companies and are often needing more funds to start extracting. With technology companies, they often have technology that is in its infancy stages, and can be made obsolete by better innovations, rendering the company useless.
Overall, you’ll need a strong stomach to be able to handle investing in penny stocks. A $20 000 investment could have $5000 to $10 000 price movements in a single day.
Where there is risk, there is significant reward
Whether you’re investing in blue-chip dividend stocks, mining stocks or penny stocks, the goal at the end of the day is to earn a profit.
Trading Canadian penny stocks is where you’ll encounter profits unheard of when trading on the major exchanges. 100% to 200% daily gains are not outside the norm. In fact, prior to the Government of Canada putting trading restrictions on your Tax Free Savings Account, some people made a fortune absolutely tax free.
A single purchase of a penny stock can change your life. But it is important to note, contrary to popular belief, penny stocks are not all luck. Although you’ll need luck on your side to avoid losses due to bad (or even straight up false) press releases, there is a lot of skill involved with purchasing penny stocks.
With that being said, lets get down to what it is going to take for you to be a successful penny stock investor.
Getting started with Canadian penny stocks
Like I said above, the first box you need to check off if you want to invest in penny stocks is the ability to handle significant volatility. If you don’t think you can stomach the risk, simply head to our how to buy stocks page to get started investing in the major exchanges.
What I like to tell investors looking to start trading the pink sheets, is to set aside an amount you would be completely comfortable losing. I wouldn’t recommend anyone invest their whole portfolio into penny stocks. But a designated amount, say 10% of your total portfolio, is completely reasonable.
Once you’ve allocated some capital towards what I like to call “fun investing”, you’ll need a brokerage account. If you already have one, you’re ahead of the game. If not, feel free to check out our Questrade review. In my opinion, they are the best brokerage to start with if you’re looking to invest in penny stocks. Take advantage of our exclusive offer for $50 in free trades with Questrade today.
Keep in mind, most brokerages charge more than their standard commission rates to buy penny stocks. This is simply due to the fact that penny stocks are traded over-the-counter, which is a little bit different than processing a transaction on a normal exchange.
What exactly is OTC (Over The Counter)
When companies aren’t listed on a normal exchange like the NYSE,NASDAQ or TSX, they are traded via a broker-dealer network. Transactions take place via a bulletin board (the OTCBB) and Pink Sheet listing services.
These broker-dealer networks communicate with each other and act as market makers. They will locate shares available for purchase or sale, along with negotiate a price for a fee.
Although most of the stocks trading over-the-counter cannot make it on the major exchanges due to regulations, they still need to meet requirements to trade OTC. It’s not only penny stocks that trade over-the-counter either. For example, companies may also issue bonds over-the-counter.
Can you “invest” in penny stocks?
The term “investing” carries with it a fairly broad definition. Some people believe that purchasing a stock right now and selling it a year later is an investment. Our definition here at Stocktrades is a little wider than that. In fact, if I’m looking to invest in something, I’m thinking of a 5 year timeline at minimum.
You won’t find many penny stocks worth holding for that period of time. So if you’re looking to get into penny stocks, you’re going to have to be an active trader.
Penny stocks can soar or take a dive in price on something as simple as a viral news report. If you’re away for a day or two with no time to check your brokerage account, you may come home to an empty wallet. This is why it is crucial if you are going to start trading over-the-counter stocks, you need to adopt a day trading strategy.
What I mean by this is if you can’t commit the day to monitoring your penny stocks, don’t trade. And never hold a position overnight. It is best to develop a cash only strategy by the end of the trading day to avoid the after market turmoil that could leave you with a useless stock and nobody to sell it to.
Avoiding the most common penny stock scams
Where there is money to be made, there will be scam artists trying to exploit people. The case is no different with penny stocks here in Canada, and before you start trading them, it’s absolutely imperative you understand how to sniff out a potential scam. Although there are endless amounts of penny stock scams out there, here are the 2 most popular ones you will see.
The Pump and Dump
A good way to identify these scams is to look at penny stock newsletters or a particular list of penny stocks.
The scammer, who owns a large portion of the security, inflates the price of a stock by making false and exaggerated claims, usually of an unknown company.
Naive investors buy and then, when a certain price level is reached – the bad guy sells. This, in turn, plummets the share price, leaving the buyer with the crumbs of what was once their hard earned dollars.
The Short and Distort
The short and distory is essentially the complete opposite of the pump and dump. This popular penny stock scam is put into action by someone making false and damaging rumors about a particular company. Right as the news is going viral, the scammer will take a short position on the company.
As the stock continues to fall because of the false news, the scammer will eventually find a price point they are satisfied with and close their short position for a large profit.
Tips when buying penny stocks
Before you get started, I’m going to drop you a few quick pointers you will need to be successful with buying penny stocks here in Canada. This is by no means a complete list, however I feel they are some of the most, if not the most important things you need to know so you don’t lose your money.
- When buying penny stocks, be aware that smaller sized entities may not be required to file documents with the Securities and Exchange Commission (SEC), something that bigger companies are required to do. This makes determining the financial health of a company nearly impossible, which is often why purchasing penny stocks is often thought of as nothing more than a gamble.
- In order to reduce your risk, try investing in companies listed on the OTCQX or OTCQB exchanges. These are essentially the top and middle tiers in terms of penny stocks, and companies listed on these exchanges will more than likely have accurate financial information, and will file it in a timely manner.
- If you’re looking for some of the highest returns, albeit highest risk, the OTC Pink is the lowest tier of penny stocks in terms of financial information provided. These stocks are the most volatile, so they bring with them highest potential profitability. Keep in mind though, the higher the reward, the higher the risk.
- There are a ton of penny stocks out there, and I would highly suggest using a screener to identify and narrow down your potential list of suitable companies.
- Knowledge in technical analysis is absolutely crucial when trading penny stocks. Because limited or inaccurate financial information is available to most investors, fundamental analysis almost plays no part in picking stocks.
- Analyze the management team. More than anything, they will be responsible for the inevitable failure or success of the company. With startups in particular, there will be a lot of key decisions made by the management team that can make or break an over-the-counter company.
What are the best websites for penny stock research?
We don’t cover penny stocks here at Stocktrades. Although we’ve developed one of the best guides on the internet to get started, individual penny stock analysis is not something we execute. However, there is a ton of excellent websites out there to help you get started.
The two most popular websites in the country are probably Small Cap Power and All Penny Stocks. Recently updated in July, Small Cap Power has an awesome article on some of the best penny stocks to buy right now.
All Penny Stocks focuses on news and technical analysis on penny stocks around the globe.
Overall, there is potential for profit with penny stocks if you put the effort in
Canadian penny stocks do have certain advantages for new investors. Because they are priced so low, you don’t have to invest too much money to get started.
If you limit yourself to companies that provide proper documents, then this is also a good place to learn to read and interpret financial statements, because they are most often short and not that complicated. It can also be beneficial to invest in penny stocks inside of a Tax Free Savings Account, as those huge returns will not be subject to tax inside of it. If you’re investing in a non registered account, you could be subject to a large capital gains bill, depending on how much you make.
Make sure you understand the company you are buying. Watch for factors like management and earnings, and understand the credibility of the stocks “narrative”.
Approach with hesitation, and question everything. This will make you a more confident and analytical investor, which will help you avoid some of the scams out there. I wish you some exciting, wonderful, and prosperous trading!